Outside the Band: Depreciation and Inflation Dynamics in Chile
IMF Working Papers, July 6, 2016
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- Outside the Band: Depreciation and Inflation Dynamics in Chile
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Bibliographic details
- Authors: Esther Perez Ruiz
- Published: July 6, 2016
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498350976.001
Summary
- Examines inflation dynamics in Chile during the peso depreciation episode 2013-15.
- Evidence points to substantial exchange rate pass-through effects to inflation given the large and persistent depreciation movement.
- Widespread indexation practices in non-traded goods markets amplify the inflation response to the depreciation; wage indexation is found to be less relevant.
- Counterfactual: inflation would have remained within the central bank’s target band absent the peso depreciation.
- Tightening monetary policy in response to a depreciation shock can be costly in terms of output: the response of activity to rates is strong, while the transmission from activity to inflation is weak.
- Simulations under uncertainty about the extent of the pass-through suggest monetary policy can play a countercyclical role in the face of depreciation shocks at a moderate inflationary cost, provided inflation expectations remain anchored.
Key findings
- Substantial pass-through from the peso depreciation during 2013-15 to overall inflation.
- Amplification channel: widespread indexation in non-traded goods markets increases inflation response.
- Limited role of wage indexation for the inflation dynamics in this episode.
- Without the depreciation, inflation would have remained inside the central bank’s target band.
- Monetary tightening following a depreciation shock:
- Strong negative effect on output (activity responds strongly to interest rates).
- Weak effect on inflation (activity-to-inflation transmission is weak).
Policy implications and recommendations
- Monetary policy faces a trade-off when responding to depreciation shocks: mitigating inflationary effects can incur sizable output costs.
- If inflation expectations remain anchored, monetary policy can act countercyclically against depreciation shocks while accepting a moderate inflationary cost.
- Policy design should account for the amplification role of indexation in non-traded goods when assessing pass-through and the appropriate policy response.
Simulations and scenarios
- Simulations consider uncertainty about the extent of exchange rate pass-through.
- Results indicate:
- Monetary policy can be countercyclical under moderate inflationary consequences.
- Anchored inflation expectations are a key condition for a successful countercyclical policy response.