1. 1 CENTRAL BANK OF CHILE Rodrigo Valdés (with José de Gregorio and Andrea Tokman) IADB - MAY 13, 2005 Flexible Exchange Rates with Inflation Targeting in Chile: Experience and Issues

2. 2 Agenda 1.The road to a flex ER regime in Chile 2.The current policy framework  Description  Brief evaluation 3.The ER and the framework at work 4.Issues  Volatility and hedging  Extreme valuations  Passthrough 5.Concluding remarks

3. 3 1. The Road to a Flexible ER Regime in Chile

4. 4 Road to Flex ER Problems with ER inflexibility. Crises in 1962 and 1982 with fixed ER. Recession after Asian crisis and ER band ER band suffered multiple adjustments affecting its credibility; ER usually near low limit Fear of floating in 1998 due to: –Passthrough in overheated economy and large CA deficit –Mismatches Capital controls during the 90s –Useful? Not central; ER regime more problematic –Dismantled after the crisis

5. 5 N F O R M E The Road to Flex Source: Central Bank of Chile Exchange Rate and Band: 1990-2005 (pesos per US$)

6. 6 N F O R M E The Road to Flex Source: Central Bank of Chile Real Exchange Rate: 1982-2005 (up is peso depreciation)

7. 7 2. The Current Framework: FFIT + Flex ER I N F O R M E D E P O L Í T I C A M O N E T A R I A

8. 8 The Current Framework Since 2000 IT with a 2 to 4% band, centered in 3% for CPI with policy horizon of 12-24 months ( “infant stage” IT with annual targets before) Forward-looking nature and band accommodates –MP lags –Unnecessary output volatility No contingencies announced Headline CPI, but core measures used to evaluate, forecast and communicate

9. 9 The Current Framework In practice, 12-24 month forecasts are the operational objective Standard instruments to communicate MP: –Monetary Policy Report –Communiqués –MP meeting minutes Floating ER regime, but CB reserves the right to intervene in exceptional circumstances –Overreaction with negative consequences –Transparency

10. 10 The Current Framework Has served well the economy... From gradual decline in inflation in the 90s to –Average 2.7% since 2000, max 4.7%, min -0.7% –2/3 of the time within the band Powerful anchor for medium term expected inflation MP has been strongly countercyclical –More than in the 90s RER adjustment to negative shocks in 2001 and 2002

11. 11 N F O R M E The Current Framework Source: Central Bank of Chile CPI Inflation and Inflation Target: 1990-2005 (percentage)

12. 12 N F O R M E The Current Framework Source: Central Bank of Chile Expected Inflation Measures (percentage)

13. 13 N F O R M E The Current Framework Source: Central Bank of Chile Countercyclical MP under IT

14. 14 N F O R M E The Current Framework Source: Central Bank of Chile RER Adjustment and External Conditions

15. 15 3. The ER and the Framework at Work

16. 16 ER and the Framework at Work MP reaction to ER is not mechanic; the nature of the shock matters –Expected path of the ER UIP enhanced with equilibrium RER discussion –Effect on inflation Direct and indirect effects Core model: passthrough 20% in one year; 25 in two years Examples: –End 2003 appreciation followed by interest rate cuts –Mid 2002 depreciation together with interest rate cuts

17. 17 ER and the Framework at Work Two intervention episodes (2001 and 2002) Why? –Probable overreaction with inflation (and MP) consequences –Informed call by CB board Fixed period (4 months), maximum amounts (US$ 4 bn) Large effects on announcement (including trend) Actual interventions used a portion of resources

18. 18 N F O R M E ER and the Framework at Work Source: Central Bank of Chile Exchange Rate Interventions

19. 19 4. Issues

20. 20 N F O R M E Issues: Volatility Source: Central Bank of Chile Exchange Rate Volatility (30-day standard deviation of daily averages)

21. 21 N F O R M E Issues: Volatility Source: Riskmetrics Exchange Rate Volatility

22. 22 N F O R M E Issues: Hedging FX Derivatives Market in Chile

23. 23 N F O R M E Issues: Hedging Source: BIS FX Market Turnover/GDP, April 2004

24. 24 N F O R M E Issues: Extreme Valuations Source: Author’s calculations

25. 25 N F O R M E Issues: Extreme Valuations Source: Author’s calculations Sq. Root Quadratic Misalignment and ER Regime (5-year averages)

26. 26 N F O R M E Issues: Passthrough Source: Author’s calculations One-year Passthrough Coefficient

27. 27 5. Concluding Remarks

28. 28 Concluding Remarks Framework has worked well… –Inflation under control and countercyclical MP –RER has adjusted substantially and there is more stability (with other developments, e.g. fiscal policy) Volatility has increased (as elsewhere?) –There is more hedging in deeper markets –Extreme valuations seem less likely Is the model a blueprint for everybody? –Institutions needed for benefits of financial opening –Overcoming fear of floating needs credible anti-inflation stance and limited balance sheet effects