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Chile raises basic rate to 4.5%, but more on the pipeline says Capital Economics

The Chilean economy is leveraged on copper prices

The Central Bank of Chile (CBC) hiked interest rates by 50bps to 4.5% on Wednesday but with the near-term outlook for growth very good and inflation likely to top 5% in Q4, further policy tightening is on the way, reports Capital Economics that estimates rates to reach 6% by year-end.

In its release the Monetary board from the Chilean Central Bank states that the ongoing spike in global commodity prices has pushed up short-term inflation expectations and that the domestic economy has shown great ‘dynamism’.

As a result, policymakers still feel that it is ‘necessary to continue to reduce the monetary stimuli over the coming months. In other words, the Board sent out a clear message that rates will rise further.

The Chilean economy is leveraged on copper prices and, therefore, the strength of global growth. While copper prices have come off a little in recent weeks, at $9,625/mt they remain close to record highs.

As a result, the continued boost to the economy’s terms of trade means that bumper domestic demand will drive growth of at least 5.5% this year.

Nevertheless, high commodity prices more generally are a double-edged sword for Chile argues Capital Economics.

Unlike in other parts of the region, an absence of domestic price subsidies means that higher oil prices in particular tend to pass through quickly into higher inflation.

Prices rose by 0.8% on the month in March, which caused the annual rate of inflation to rise to 3.4% (from 2.7% in February) – above the centre-point of the CBC 2-4% target range. And with the lagged effect of the recent spike in food prices still to be fully felt it can be expected inflation to peak at around 5% in Q4 this year, averaging 4% in 2011 as a whole.

The spike in inflation should prove temporary, but underlying inflation pressures are mounting. Core prices rose by 0.4% on the month in March and, with unemployment on a downward trend and wage growth accelerating, it can be expected prices to accelerate further. This will at least partially offset the fall in food and energy inflation and keep the CPI rate above target next year.

Capital Economics estimates inflation to average 3.5% in 2012.

But the upshot is that, with the outlook for growth still good, policymakers look set to focus on tackling inflation in the near-term. Further monetary tightening is therefore on the way. We now expect rates to reach 6% over the coming months (previously 5% by year-end), accompanied by continued FX purchases to prevent the peso from appreciating beyond 460 Pesos to the US dollar.

Finally Capital Economics expects some pull back in copper prices over the next year or so, which will not make the Chilean economy collapse, GDP can slow to a below consensus 4.5% next year. This is the key reason why we doubt that rates will reach the 7% which are currently priced into the market for next year, concludes Capital Economics.