With the Central Bank of Chile’s policy rate at its effective lower bound, we think that its next easing measure would be a quantitative easing programme aimed at flattening the long end of the yield curve.
- With the Central Bank of Chile’s policy rate at its effective lower bound, we think that its next easing measure would be a quantitative easing programme aimed at flattening the long end of the yield curve.
- Chile’s central bank has eased policy aggressively in response to the current crisis. It slashed its policy rate by a total of 125bp last month, to 0.50%. And it introduced a lending facility (the FCIC) to provide liquidity to banks that continue to lend and refinance consumer and business loans. This carries a fixed interest rate set at the current policy rate and has a maturity of up to four years.
- The central bank also launched a bank bond purchase programme worth 1.8% of GDP. This (like bond purchase programmes introduced recently in other EMs) was aimed primarily at increasing liquidity and reducing credit spreads. (See our Emerging Markets Update.)
- The central bank has stated that it considers 0.5% to be the “technical minimum” for its policy rate in order to allow the money market to function effectively. And it didn’t lower the policy rate below this level after the global financial crisis. This begs the question of what the central bank can do next to ease policy as Chile’s economy continues to face coronavirus-related disruption.
- One option is simply to lower the policy rate below its technical minimum. The central bank has, after all, admitted that it could revise its view of the effective lower bound. And other central banks such as the Bank of England and Reserve Bank of Australia have lowered policy rates below what they previously considered the effective floor for rates. As things stand, we think it’s more likely than not that Chile’s central bank will lower its policy rate by a further 25bp, although this won’t happen immediately.
- The very near-term focus is, instead, likely to be on unconventional easing to flatten the long-end of the yield curve. The short-end of the yield curve is already pretty flat – local currency sovereign bond yields out to two years stand at 0.5-0.6%. This has probably been helped by the FCIC programme. But the longer-end is still steep. For example, the yield on five-year local currency bonds stands at around 1.7%, and the yield on 10-year bonds is about 3.4%. The latter has hardly moved during the recent crisis.
- The most obvious way to try to bring these yields lower would be with a quantitative easing (QE) programme. This was used by DM central banks after the Global Financial Crisis once they had exhausted conventional policy easing. It works by expanding the size of the monetary base and, unlike recent bond purchases, is aimed at affecting the long-term structure of the yield curve by reducing term premia.
- Admittedly, there are some barriers to implementing QE. No EM central bank has embarked on QE before, and an expansion of the central bank’s balance sheet may spark fears of inflation. However, we don’t think this would be an impediment to QE in Chile. The central bank’s independence and credibility are well-established and inflation expectations are well-anchored. Break-even inflation expectations derived from inflation-linked bonds have been pegged close to the 3% target for more than a decade.
- The main barrier is that the constitution prevents the central bank from buying government bonds. Policymakers could expand the current bank bond purchase programme, although we suspect that they would prefer initially to purchase sovereign debt so as not to distort credit spreads more than they already have. In any case, legislation has been introduced in the Senate to allow the central bank to purchase government debt. The latest reports suggest that this is more likely to be approved than rejected.
- Ultimately, the key determinant of whether Chile’s central bank actually adopts QE depends on how the economic shock from the coronavirus evolves in the coming months. If, as we think is likely, containment measures last through much of the second quarter, the scale of the economic contraction will be severe and will probably prompt a shift towards further easing.
- There’s is a rich debate about just how effective quantitative easing has been in advanced economies, but its track record at boosting growth and inflation is less than impressive. (See our Global Economies Focus.) And QE certainly wouldn’t prevent a deep recession this year. That said, it should help to bring down longer-term interest rates – something the markets don’t currently seem to be discounting – which might help Chile’s economic recovery when the effects of the coronavirus fade.
Quinn Markwith, Latin America Economist, firstname.lastname@example.org