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Axel Christensen

Chile's economy was on track to show above-trend growth when the February 27 earthquake struck. The initial reaction from economists and market analysts was that the quake would have a double-whammy effect by delaying the recovery in economic activity and creating short-term inflationary pressures due to output constraints. This was not an easy scenario for Chile's Central Bank to face, especially having stated its intention before the earthquake to start on the path back to normal monetary conditions.

But things have turned out to be easier than expected. Despite higher-than-anticipated inflation in May, June inflation came in at zero percent, which surprised market analysts as a tax increase on tobacco to help fund the reconstruction was compensated by lower prices for other items included in the price index. So it seems the feared short-term inflationary pressures that were supposed to stem from output restrictions due to the earthquake did not materialize.

A tamer inflationary scenario was not the only relief for the central bank. Economic activity staged an impressive comeback with May activity showing 7% year-on-year growth as measured by the monthly IMACEC indicator. In addition to the impact of reconstruction initiatives, the activity growth is also explained by strong retail numbers and a pick-up in construction.

The central bank has also been helped by President Piñera's balanced funding plan for reconstruction. Finance Minister Felipe Larraín announced that the public monies required for this endeavor would come from a combination of reorganizing budget allocations, increasing taxes - most of them on a temporary basis - and reducing evasion, issuing debt and using part of Chile’s savings in its sovereign wealth funds.

This balanced approach reduces the risk of stressing out two of the key variables monitored by the central bank. Too much debt would have an impact on interest rates, as an increasing supply of government paper would put up-side pressure on longer term rates. On the other hand, too much reliance on sovereign wealth funds in foreign currency could have upset the exchange rate, with exporters already complaining about the negative effects of a stronger Chilean Peso.

Using a mix of financing sources for reconstruction has allowed the central bank to return to its original plan of withdrawing monetary stimulus gradually. It began the long road back to a neutral rate with a higher-than-consensus 50 basis points rise in June after most market analysts had expected a more gradual first step of only 25 points. A second 50 basis point increase in July, however, came as no surprise, placing the monetary policy rate at 1.50 percent.

The market expects that the bank will take its time to reach what is considered a neutral monetary policy rate of 5.5 to 6.0 percent, anticipating that these levels will not be reached before mid-2011 with inflation converging to around 3.0 percent by the end of this year. For 2010, most forecasts see year-end interest rates closing within the 2.5 to 3.0 percent range, almost double current rates, but still quite accommodative in real terms.

What could go wrong on what is expected to be a pretty smooth ride? On the side of pushing the bank towards a more aggressive pace is higher than expected inflation, which is not uncommon as output gaps start to close. A faster pace may also be driven by external factors, such as the recently announced 8.0 percent average increase in electricity tariffs due to, among other things, the impact of long-term contracts negotiated between distribution and generation companies at a time of scarce supply.

There is also the risk that the bank might have to slow its pace in returning to monetary neutrality. This might happen if, for example, another downturn in global growth, with the corresponding drop in copper prices, causes a slowdown of the Chilean economy.

But let’s hope that rates continue to rise at a moderate pace while the post-earthquake fears of higher inflation and a delayed recovery are put to rest for good.

Axel Christensen is Managing Director of BlackRock for South America ex Brazil.