Published on April 14, 2008
Slide1: Exchange Rate Policy and Inflation Targeting in Colombia Hernando Vargas Banco de la República May 2005 Slide2: Exchange Rate Policy and Inflation Targeting in Colombia Main ideas I. Inflation Targeting (IT) has worked well in Colombia II. There has been an “Independent” floating exchange rate regime with two managed floating episodes … III. 2003-I: Dealing with a sharp depreciation IV. 2004-II – Present: Dealing with a sharp appreciation Political economy issues: Political context in which monetary policy is made in Colombia Conclusions Slide3: IT has worked well in Colombia A. Background Between 1973 and 1990 Colombia experienced moderate inflation (15%-30%). A crawling peg regime with capital controls was in place since 1967 In 1991 the Central Bank was granted independence with the goal of preserving the purchasing power of the currency. It started a process of gradual disinflation Some exchange rate flexibility was introduced (crawling exchange rate bands) and intermediate monetary targets were used to guide policy Most capital controls were removed between 1991 and 1993 . Slide4: In the presence of large fiscal and external imbalances, the terms of trade shocks and the “sudden stop” of 1998-1999 forced the abandonment of the exchange rate bands in September 1999 GDP fell by 4.2% in 1999 and a financial crisis ensued involving state-owned and some mortgage banks. A floating regime was established and monetary policy converged to an IT framework Slide5: Initial conditions of IT: Inflation had fallen from 16.7% in December 1998 to 9.2% in December 1999, but was still above the long run target (2%-4%) Deep recession The credit channel was weakened by the financial crisis The currency depreciated by 22% in real terms between January 1998 an December 1999 within the band system International reserves level was considered too low after the defense of the bands Several elements of IT were already present: Explicit inflation targets (1991), forecast models (since 1995) and an early version of an Inflation Report was being published since December 1998 Slide6: In this context, the initial objectives of monetary and foreign exchange policy were: To continue gradual disinflation towards its long term target To restore international reserves (IR) to levels that would limit the external vulnerability of the economy Considering the state of the economy and the need to bring output close to its “potential” level, a gradual approach to disinflation (as opposed to an alternative “opportunistic” approach) was adopted “Flexible” IT (Svensson, 2000). The short term Central Bank´s REPO interest rate was identified as the main instrument of monetary policy Slide7: The floating exchange rate regime added transparency to the strategy. Unlike the previous period, there were no explicit or implicit exchange rate targets So, intervention in the for-ex market was initially limited to: Accumulate IR and restore their level (1999) Curtail excessive volatility (1999) There was no intention to affect the exchange rate trend Later a facility was created to support monetary policy in case of a sharp depreciation of the currency (2001) Intervention was announced, rules-based and worked through auctions of options to sell/buy dollars to/from the CB Transparency: Avoids legal risks for CB, consistency with monetary policy easily verifiable, strong signaling effect More recently, discretionary intervention was added to the menu (2004) Slide8: B. Performance Taking into account the initial state of the economy, the CB reduced its interest rates by 550 bps between 2000 and 2004… …Allowing 3-month CD rates (the benchmark interest rate for Colombia) to keep real values well below its historical average for the whole period . Slide9: This was consistent with the reduction of the output gap and increasing growth rates . Slide10: …While inflation continued its decline and was on target in 2004 Inflation expectations have also fallen, and the credibility of the inflation targets has increased . Slide11: International reserves reached comfortable levels, as reflected in several indicators of external liquidity . Overall it can be concluded that IT has worked well in Colombia Slide12: II. “Independent” Floating The exchange rate regime between 2000 and 2005 may be characterized as “Independent Floating” (Bofinger and Wollmerhäuser, 2003) . Slide13: The degree of exchange rate flexibility has been similar (even higher) than in other countries in the region with similar regimes . Slide14: For-ex intervention has not been inconsistent with monetary policy… … Capital controls have not been used: There has not been “Impossible Trinity” problems Slide15: However there have been two episodes that may be characterized as managed floating periods: 2003-I Semester 2004-II Semester – Present Slide16: III. 2003-I: Dealing with a sharp depreciation In 2002-I, inflation was declining, after two years of achieving the targets, Output gap was negative and… The Col peso had been appreciating since mid 2001 In these circumstances, two external shocks hit the Colombian economy… Risk premia increased in most countries in the region due to political uncertainty in Brazil … Slide17: … Economic problems and foreign exchange restrictions in Venezuela caused a reduction in export revenues Slide18: As a result, the Col peso depreciated by more than 30% between April 2002 and February 2003. The effect of this depreciation on the prices of imported and tradable goods was clear: Slide19: Although “pass through” is low in Colombia, the size of the depreciation threatened the achievement of the inflation targets Shocks to food prices by the end of 2002 increased such a risk Slide20: Monetary authorities were aware that the shocks were transitory, but: They were uncertain about the persistence of the external shocks, Inflation expectations rose to levels deemed as inconsistent with the targets and inflation forecasts were also above the targets Slide21: Therefore, the CB policy response was particularly strong: CB REPO interest rates were raised by 200 bps between January and April 2003 The idea was to send a clear signal about CB´s commitment to the inflation targets However, The presence of a negative output gap and The uncertainty about the connection between CB interest rates and the exchange rate… Induced the CB to complement its monetary policy decisions with for-ex policy actions… Slide22: … In February 2003 the CB announced that it was willing to sell up to US$ 1000 m through July, by means of auctions of call options The peso stopped depreciating in April and the CB sold US$ 345 m out of the maximum of US$ 1000 m that it had announced. The peso started to appreciate slowly in October and inflation ended the year above the range target, but with a clear declining trend Slide23: Lessons: The announcement and the intervention in the for-ex market were useful to complement the monetary policy decisions Exclusive reliance on interest rates to moderate the depreciation and inflation expectations would have probably implied larger increases in interest rates and inefficiently higher volatility of output. The intervention announcement was useful because it was credible. And it was credible because: It came with changes in the stance of monetary policy It came after a substantial depreciation It was not excessive, given the initial level of IR (US$ 11.100 m or 1.1 times external debt payments). Slide24: IV. 2004-II - Present: Dealing with a sharp appreciation In 2003 the Col peso appreciated less than other Latin American currencies (due to the fall in exports to Venezuela) In 2004 the peso caught up Slide25: Reasons behind the appreciation: Low international interest rates and spreads (depreciation of the dollar) Higher portfolio and short term debt net inflows Increasing FDI (higher oil and coal prices) Capital account rose from 1% of GDP in 2003 to 3.5% of GDP in 2004 Higher world growth and growth of trade partners (especially Venezuela) Larger export volumes and prices (TOT). Although some of these factors have persisted in 2005 (e.g. high oil and coffee prices), …. Others are more uncertain (capital flows) Others might not be permanent (TOT, oil export volumes?) Thus, part of the appreciation might not be permanent Slide26: At the same time, the IT analysis showed: A continuous reduction of core and tradable inflation throughout 2004 Significant reductions of inflation expectations and record high credibility of the inflation targets A stabilization of non-tradable inflation and, later, convergence to the inflation target…. …Which is a signal of a slowly closing output gap Higher probability of inflation being below target at relevant horizons Slide27: Thus, the IT analysis suggested that it was feasible to reach the inflation targets with a looser stance of monetary policy The CB decided to relax monetary policy by means of two coherent instruments: Reduction in CB REPO expansion interest rates (25 bps in February and December) and closing of REPO contraction facilities (December) Partially sterilized intervention in the for-ex market The use of the second instrument was justified on the grounds of the temporary nature of part of the appreciation The conclusions of IT allowed the use of foreign exchange to: Restore IR level (after the sales of 2002 and 2003) Avoid large reductions of interest rates (curtailing output or inflation volatility) Protect tradable sector against a sharp, temporary appreciation (Hysteresis hypothesis)… Consistent with the achievement of inflation targets Slide28: CB bought US$ 2.900 m in the for-ex market in 2004 (about 26% of the initial level of IR) US$ 1.577 m were purchased through the put-option system, mainly between January and August The remainder (US$ 1.323 m) was purchased through discretionary intervention, introduced in September of 2004 Discretionary intervention was regarded as more effective than the put-option mechanism under the conditions of a sharp appreciation and expectations of a rapid appreciation The effectiveness of discretionary intervention increased since December 2004, when: Monetary policy was relaxed (interest rates were reduced and the contraction REPO facilities were closed) No announcement on the size or the horizon of intervention was made This is the prevailing intervention system Slide29: Lessons and challenges: For-ex intervention became more effective when accompanied by changes in monetary policy in the same direction. Intervention has limits and challenges: If IT indicates the need to tighten monetary policy, intervention will have to be reduced or eliminated… …Otherwise, the CB could incur in credibility and cuasi-fiscal costs. CB has publicly stated this possibility With intervention, larger efforts are required to communicate policy and emphasize consistency Too large an intervention may change the position of the CB from creditor to debtor of the financial system. This change is considered inconvenient for reasons of monetary control Slide30: V. Political Economy Issues The Government regards the RER as a key element in its security strategy Could requests from the Government for a depreciated RER weaken the credibility of monetary policy? Domestic public bond market is relatively large (outstanding stock is 23% of GDP) and central Government deficits persist at 5%-6% of GDP. Is it possible to have a conflict between the sterilization of intervention and the cost of Government financing? Could this conflict compromise CB credibility? Could CB losses resulting from excessive sterilized intervention weaken its position against the Government or Congress? Some sectors in Congress have requested the use of IR to reduce public external indebtedness. Do these actions hamper CB independence and credibility? Slide31: VI. Conclusions Since September of 1999 monetary policy in Colombia has converged to a full-fledged IT strategy with an “independent” floating regime. The performance of the strategy has been satisfactory overall. Starting from a deep recession, the policy stance has been expansionary. Inflation has declined along decreasing targets, output has recovered and international reserves have reached levels that limit the external vulnerability of the economy. Intervention in the for-ex market has been consistent with the stance of monetary policy. As a result, capital controls have not been used by the central bank since 1999. There have been two episodes of managed floating characterized by strong shifts in the exchange rate. Slide32: They have taught us that intervention in the for-ex market could be a useful complement of monetary policy actions. I.e. that relying only on the interest rates to deal with shocks to the capital account of the balance of payments may lead to inefficient volatility in inflation or output. We have also learned that intervention without consistent movements in monetary policy has not been very effective to modify the trend of the exchange rate. The CB is aware of the possibility of conflicts between IT policy recommendations and intervention. It has publicly stated that these conflicts would imply the reduction or elimination of intervention because inflation continues to be the primary goal of CB policy. Fiscal imbalances may pose a threat to the credibility and power of monetary policy through several “political-economy” channels.