The odds the central bank increases the monetary stimulus in coming months are not small, although not our base scenario.

We are lowering our yearend inflation forecast to 1.8% (from 2.4%) for this year. Our revision is not only due to the downward surprise to inflation in September (which came in at -0.2% month-over-month) but also considers the lagged effect of the prolonged strong performance of the Chilean peso. Furthermore, given an atypically low inflation in 3Q, annual inflation is expected to remain below the 2%-4% target range for the next 11 months, ending next year at 2.8%. However, risks to our 2018 forecast are tilted to the downside, so the odds the central bank increases the monetary stimulus in coming months are not small, although not our base scenario.

While inflation has been low for most of the year, it was in 3Q17 when prices significantly departed from historical figures. Affected by the September print, accumulated inflation in the quarter was only 0.3%, compared to the 0.8%-1.6% range for 2010-2015 and 0.5% in 2016, the year when inflation returned to the target range after a 2-year excursion above 4%. In fact, inflation for a comparable quarter was only lower in 2009 (+0.2%), in the midst of the global financial crisis. Low inflation was mostly due to volatile components (such as food items: 1% in the quarter, far lower than the typical 3%-4%) and tradable goods prices (0.1%, versus 1%-2.5% in past years).

Yet, we expect inflation to normalize in coming quarters, returning to the 2%-4% range by 3Q18 and to the target within the 2-year monetary policy horizon. High frequency price tracking is pointing at an October inflation print of 0.2%-0.3%, while we expect November and December CPI to come in between 0% and 0.1%, leading to an accumulated inflation of 0.2%-0.5% in 4Q17 (compared with 0% one year before). Looking to next year, our expectation for higher inflation relies on the assumption that the Chilean peso depreciates by 6% from September-end levels (led by the gradual unwinding of the monetary stimulus in the U.S. and some moderation in copper prices in coming quarters), a narrower output gap and a normalization of inflation for non-processed food (-11.5% year over year in September). Well-behaved inflation expectations will also contribute to lift inflation next year. Furthermore, while inertia will certainly contribute to maintain inflation low next year, we note that minimum wage increase (a key element of inertia) for next year was already set at 3.4%, much before the recent fall of inflation.

Our baseline scenario is for the central bank to leave the policy rate unchanged at 2.5% for most of next year, but we cannot rule out additional rate cuts. In the most recent monetary policy decision, the central bank reiterated it would lower interest rates further if it judges that the recent evolution of inflation threatens the convergence of inflation to the target in the relevant monetary policy horizon (2 years). Given inertia, the benign environment for emerging markets (which benefits the Chilean peso) and a still-incipient activity recovery, we think the odds of such risks materializing are not small.

Miguel Ricaurte

Vittorio Peretti