The Chilean peso has been rising against the dollar for the past year. It has surged from Ch$750 to the dollar to Ch$565. This brought the peso back to where it was in early 2001. In the first half of January, the peso rose by 4% against the dollar. In 2003, it rose by 26% against the dollar.
The central bank president, Vittorio Corbo, made it very clear on 27 January that the bank has no intention of intervening in the foreign exchange market. He said he had no sympathy for exporters because, even with the peso at its current level, they were still highly competitive.
The fuel for the rise in the peso has been the surging copper price. When fears surfaced at the end of January that China may cut back its copper purchases, the peso went off the boil. The currency dipped to Ch$580 to the dollar. Chile is the world's biggest exporter of copper. In 2003, copper prices rose by 49%: this was the biggest 12-month jump since 1994.
The main domestic consequence of the strength of the peso is that inflation is undershooting. The central bank is aiming to keep inflation in a band between 2% and 4% a year. It runs its policy with a two-year horizon. So when policymakers reckoned, according to the December minutes of the central bank's monetary policy committee meeting, that inflation would get nowhere near 3% by the end of 2005, the committee took the decision to cut rates. They repeated the dose again in early January.
Inflation is indeed very mild, coming in at just 1.1% in 2003 (the lowest level since 1935, and down from 2.8% the year before). The worry among independent economists is that the low level of inflation does not reflect the buoyant level of domestic demand. Indeed, the central bank's own economists, all renowned inflation-warriors, recommended that the monetary policy committee should hold rates at 2.75% in December.
This advice was not heeded in December, and it was disregarded again in January when rates were cut by another half point. The inflation warriors argue that, although demand had slowed down in the third quarter, there was plenty of evidence to suggest that it had picked up again in the final quarter of the year.
Reasoning
The central bank reckons that each half-point cut in interest rates will raise the underlying inflation rate by 0.1% in the first year and 0.2% in the second year, so the total effect on inflation will be to raise it by 0.3% by the end of 2005. The bank also argues that the lower interest rates will lead to a somewhat faster rate of economic growth.
The central bank's December minutes show that policymakers were swayed more by the argument that, although the level of nominal interest rates has been falling, given the falling levels of inflation, the real level of interest rates has actually been rising.
The risk in cutting rates further is that the central bank is stoking up a consumer boom. Such a boom could lead to imbalances in the economy before inflation starts to rise. The fact that the bank has cut rates by a full point over its last two meetings shows that it is more worried about the threat of deflation.
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