Finally, the price hikes began feeding back into inflation expectations. Facing the resurgence of inflation, we sped up the process of raising the monetary policy interest rate (MPR). Between June and September of 2008, we increased it 200 basis points. In September of that year, when we still thought we would continue to raise the interest rate in order to bring inflation back to the target – as we had said in Congress early that month – came the Lehman Brothers debacle, and the rest is history. Uncertainty and fear took over investors, consumers and entrepreneurs. Consumers postponed expenses; firms interrupted their projects and depleted inventories; manufacturing production collapsed; demand plummeted; commodity prices fell sharply and the global recession followed. Chile was not spared. Domestic demand also fell with unprecedented force. Sales came to a halt (figure 5). Although the inflation scenario was still complex – it peaked at 9.9% in October 2008 – , a slowdown was foreseen that suggested changing the orientation of monetary policy. Growth projections plummeted unusually fast in every region of the world, going from a moderation to a recession (figure 6). Chile was no exception. In November 2008 we modified our predictions and pointed out that the economic slowdown would entail a drop in inflation, not only because of the sharp fall in commodity prices, but mainly because of the sudden creation of output gaps. We then observed that most likely we would begin cutting down the MPR in the coming months, which set out the process of financial easing.
If wages are slow to adjust, higher productivity growth lowers unit labour costs and thereby reduces price inflation. Here again there are important questions for policymakers. Should this effect be allowed to result in a temporary reduction of price inflation or unemployment? Third, an increase in the trend rate of productivity growth could also result in a higher equilibrium real interest rate, when the output gap is closed, in order to balance saving and investment. Fiscal policy and the development of public financial balances could at least partly offset this effect, as could the economy’s degree of openness. All this implies that monetary policymakers could face quite a few challenges. One of them is to identify structural changes and distinguish these from cyclical variations. Another challenge is to detect the magnitude of the effects. Furthermore, looking ahead in monetary policy is hard when the economy is going through major changes that make it difficult to forecast the future path of the economy and inflation. 5  BIS Review 65/2000  It is quite clear that this demands a great deal of forecasters as well as of those who construct macro models. The forecasts concern inflation one to two years ahead, which calls, for instance, for reasonable precision in the measurement of the output gap and the relationship between the output gap and inflation. It is already evident, for example, that inflation forecasts were frequently on the high side in many countries in the 1990s.