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June 16, 2010 Reading Time: 2 minutes

Chile has rebounded strongly from the global recession, in spite of the devastating earth quake that hit early in 2010.

In response to the financial crisis, the monetary authorities cut its key lending rate from 8.25 per cent in September 2008 all the way down to 0.5 percent in July 2009 where it has stayed for almost a year. But now this monetary stimulus is pushing the economy towards overheating. In April, the economy grew at its fastest rate since 1996 and inflation is rising.

Continued low interest rates will push the economy into an unsustainable path, which is why the central bank has started to tighten. It just hiked the policy rate by 0.5 percent and is expected to raise it to 2.5 percent by the end of the year.

The central banks of Brazil and Peru have already raised their policy rates twice this year. Monetary policymakers worldwide have began to exit from monetary stimulus as continued low interest rates threaten to ignite inflation.

However, a Chilean policy rate of 2.5 percent will still be highly stimulative, and if continued for too long could lead to a situation in which inflation needs to be reined in through substantial interest rate hikes. This, in turn, could trigger a new cooling off of the economy–leading to the so-called stop-go cycle of monetary policy in which the central bank takes the economy out of and back into recession.

If rates are pushed too high, this could risk an inflow of destabilizing capital flows, due to the exceptionally low interest rates in the U.S. and EU. On the other side, if the world economy slides back into recession, commodity exporting countries, like copper-producing Chile, will be affected. Emerging markets thus find themselves in a difficult position in trying to navigate their way out of current circumstances.

Marius Gustavson

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