Chile’s Inflation Targeting and Monetary Policy

Posted on Apr 13, 2025 in Business Administration and Management (BAM)

Chile’s Monetary Policy Framework

Under inflation targeting, the primary objective of monetary policy is price stability. It also aims to reduce the gap between actual output and potential output (full employment product), thus helping to reduce volatility in both inflation and output.

The parameters defining Chile’s inflation-targeting monetary regime are:

  1. The price index defining the target.
  2. The target value (center of the range).
  3. The width of the target range.
  4. The policy horizon.
  5. Operational instruments.

Why a 3% Inflation Target?

Maintaining an inflation rate significantly below 3% can incur costs due to several factors:

  1. It could increase output and employment losses during negative economic shocks.
  2. The Consumer Price Index (CPI) may overstate actual consumer inflation in Chile.
  3. Monetary policy loses flexibility when inflation is near or below 0%, limiting how low the real interest rate can be pushed.

Communicating the Target Range

The defined target range communicates three key aspects to the public:

  1. The Central Bank of Chile (BCCh) tolerates temporary deviations from the 3% target, recognizing they are often unavoidable due to various shocks affecting the Chilean economy.
  2. It indicates the expected level of normal inflation variability over the business cycle.
  3. The symmetry of the range shows the BCCh views deviations above and below the target with similar concern.

Policy Horizon Explained

The operational objective is to ensure projected inflation reaches 3% per year within a policy horizon of approximately two years. This horizon represents the typical maximum period over which the BCCh aims to guide inflation back to the target.

Operational Instruments: The Policy Rate

The primary operational instrument is the BCCh’s Monetary Policy Rate (MPR). Through open market operations, the Bank influences overnight interbank lending rates, aiming to keep them close to the MPR.

Flexible Exchange Rates and Interventions

Key advantages of a flexible exchange rate include:

  • Facilitating economic adjustment to real shocks.
  • Preventing persistent exchange rate misalignments.
  • Avoiding costly adjustments in output variability.
  • Mitigating potentially speculative capital movements.

A developed domestic financial system and credible anti-inflationary policy enable the monetary authority to use its instruments flexibly and independently, responding effectively to economic shocks. This aids in aligning the output level with the economy’s productive capacity.

Inflation and Monetary Policy Transmission

Monetary policy’s primary contribution to economic growth is fostering a stable, low-inflation environment conducive to development. The quantity of physical currency (banknotes and coins) does not determine long-term economic growth.

Within an inflation-targeting framework, the main policy instrument is the interest rate, not the money supply directly, although this doesn’t negate the relationship between money and prices. On average, price increases align with inflation targets and expectations. Agents infer the future path of interest rates from the BCCh’s communications and actions, which ultimately determines inflation.

Rationale for Policy Rate Changes

Changes to the policy rate are typically made for two primary reasons:

  1. When inflation projections deviate from the target.
  2. When the expected path of the policy rate needs adjustment to maintain the appropriate level of monetary stimulus, based on new information and updated projections.