Diapositiva 1

1
Exchange Rate Policy and Inflation Targeting in
Colombia Hernando Vargas Banco de la
República May 2005
2

• 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

3

• 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
• .

4

• 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

5

• 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

6

• 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 Banks REPO interest rate
  was identified as the main instrument of monetary
  policy

7

• 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)

8

• 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
• .

9

• This was consistent with the reduction of the
  output gap and increasing growth rates
• .

10

• 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
• .

11

• 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
12

• II. Independent Floating
• The exchange rate regime between 2000 and 2005
  may be characterized as Independent Floating
  (Bofinger and Wollmerhäuser, 2003)
• .

13

• The degree of exchange rate flexibility has been
  similar (even higher) than in other countries in
  the region with similar regimes
• .

14

• For-ex intervention has not been inconsistent
  with monetary policy

Capital controls have not been used There has
not been Impossible Trinity problems
15

• However there have been two episodes that may
  be characterized as managed floating periods
• 2003-I Semester
• 2004-II Semester Present

16

• 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

17

• Economic problems and foreign exchange
  restrictions in Venezuela caused a reduction in
  export revenues

18

• 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

19

• 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

20

• 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

21

• 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 CBs
  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

22

• 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

23

• 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).

24

• 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

25

• 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

26

• 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

27

• 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

28

• 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

29

• 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

30

• 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?

31

• 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.

32

• 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.