That is, monetary policy must worry about, and act upon, unstable dynamics that can lead to increases in inflation that may later be too costly to contain. These are the undesired second-round effects that may require strong monetary policy actions. In a flexible inflation targeting regime, once there are deviations from the target, monetary policy is implemented on the basis of bringing back inflation projection towards the targeted level within a given time horizon. In Chile, this would mean bringing down projected inflation to 3% in the two year horizon. This length of the horizon takes into account the lags in the effects of monetary policy, as well as the fact that bringing back inflation to target has an output cost. It also allows for transitory shocks to undo their effects without shifting the path of monetary policy. Therefore, in the current context of sharp inflationary pressures, monetary policy must avoid undesired second-round effects, which are those that generate an adjustment longer than the one envisioned in the policy horizon. In order to monitor these potentially undesired second-round effects, we scrutinize price dynamics that appear to be out of the normal. For example, we follow the evolution of wages compared to an estimated evolution of wages based on the historical patterns of indexation. If wages are growing faster than these estimates, we could be facing worrisome wage dynamics that may require a policy reaction.
Again, as noted, we have a variety of tools to remove excess reserves at a time when that becomes appropriate. As a result, I agree with many forecasters who expect disinflation in the near term. The substantial excess capacity in labor markets that I mentioned earlier has caused compensation to decline quite markedly (see Figure 11). Because employee compensation is the main cost component for most companies, lower labor costs enable businesses to improve profit margins without substantial price increases – particularly as the demand for goods and services improves. This brings us back to Yogi Berra, who famously said, “When you come to a fork in the road, take it.” At times, a fork in the road is exactly what confronts monetary policymakers. We would face a fork, for example, if inflationary pressures were building despite a high unemployment rate. In this case, the choice between restraining inflation and supporting employment is a difficult one, and the policy decision becomes more complicated. However, with employment well below the level of full employment, and disinflation continuing to move us away from my own inflation target of 2 per cent, one does not currently need to make such trade-offs. Another possible complication could occur if very low interest rates were causing excessive, leveraged bets that were inflating the price of assets that have macroeconomic importance. While we need to be vigilant against the buildup of asset bubbles, there is little evidence of such a problem now.