Abstract
This Selected Issues paper provides background information and analysis on recent developments and critical issues for the Colombian economy. The study discusses the unemployment and stresses in the financial system and also focuses on fiscal issues. The following statistical data are presented in detail: national accounts at current prices and at constant prices, savings and investment, value of agricultural crops, mining production, structure of regular gasoline prices, indicators of construction activity, minimum wages, producer price index, interest rates, and so on.
IV. Inflation Targeting in Colombia41
A. Introduction
50. In September of 1999 Colombia abandoned its crawling peg exchange rate regime and allowed the peso to float, beginning a period of greater flexibility in monetary policy. Before this, the Banco de la República had operated monetary policy through a system in which base money and the nominal exchange rate were chosen within tolerance bands to achieve the objectives for inflation.42 While this system could be considered to have some of the elements of inflation targeting (in particular, an inflation objective has been announced annually since 1991), it was not until the end of 2000 that the central bank decided formally to adopt inflation targeting as the framework for its monetary policy (Banco de la República, 2000).
51. Colombia’s decision to adopt inflation targeting follows on the successful use of inflation targeting among some industrial countries, and the adoption of most of the elements of the strategy by a small group of emerging market countries.43 While there are different institutional and operational issues in the conduct of inflation targeting in the various countries, the main elements comprise: (i) the public announcement of medium-term numerical targets for inflation; (ii) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated; (iii) an information-inclusive strategy in which many other variables, and not just monetary aggregates or the exchange rate, are used for deciding the stance of monetary policy; (iv) a transparent monetary policy that ascribes a central role to communicating to the public and the markets the plans, objectives and rationale for the decisions of the central bank; and (v) mechanisms that make the central bank accountable for attaining its inflation objectives (Mishkin et al., 2000). In essence, inflation targeting countries use the inflation forecast as an intermediate target for monetary policy, and implement their policy in a transparent and accountable framework (Svensson, 1998).
52. Countries have been moving toward an inflation targeting framework because of the advantages it offers over using the level of monetary aggregates or the exchange rate as a nominal anchor. First, it does not require a stable relationship between monetary aggregates and inflation, a relationship which has become increasingly volatile with innovations in financial intermediation and has complicated the use of intermediate monetary aggregates to control inflation. Instead of focusing on a monetary aggregate or the exchange rate as an intermediate instrument, inflation targeting allows all relevant information to be used to forecast inflation and to develop policy actions to achieve the target (Mishkin et al., 1997). Second, the inflation target is easily understood by the public, and if implemented in a transparent and consistent fashion, increases the accountability of the monetary authorities and the credibility of monetary policy. Third, unlike targeting the nominal exchange rate, inflation targeting allows the monetary authorities to respond to short-term shocks with some flexibility, while keeping the long-term focus of monetary policy on price stability (IMF, 2000). However, the successful implementation of inflation targeting is quite demanding, requiring a strong fiscal position, a well developed and healthy financial sector, a good knowledge of the monetary transmission mechanisms through which the instruments of monetary policy affect inflation, and the ability to forecast inflation relatively accurately.
53. This chapter describes the steps taken to implement inflation targeting in Colombia and evaluates some of the challenges that remain for the conduct of monetary policy. Section B briefly describes the conduct of monetary policy before inflation targeting was introduced. Section C describes the main features of the implementation of inflation targeting in Colombia. Section D concludes with a brief evaluation and some challenges that remain in the conduct of monetary policy.
B. Monetary Policy Before Inflation Targeting
54. The announcement of inflation objectives began in Colombia in the early 1990s. In 1991, a new constitution established the independence of the Banco de la República and mandated that the design and execution of monetary, exchange rate and credit policies was the exclusive purview of its board of directors. In addition, the Colombian constitution stated that the Banco de la República had the responsibility to “preserve the purchasing power of the currency” (article 373), and in 1992 a new law (Law 32) mandated that the board of directors announce a quantitative inflation objective each year (Darío Uribe et al., 1999). In addition, the legal framework prohibited the central bank from financing public sector activities and placed tight limits on the bank’s financing of government deficits.
55. In the early 1990s, the conduct of monetary policy was based on intermediate targets for the monetary aggregates. The board of directors of the Banco de la República announced a yearly band for the growth of the aggregates, which were to remain valid unless there were substantial changes in macroeconomic indicators or severe disturbances in financial markets (Darío Uribe et al., ibid). In addition to the monetary base, from 1994 until 1999 the board of directors also announced a band for the nominal exchange rate with respect to the U.S. dollar, adjusting the rate of crawl of the central parity of the band to approximate the difference between the domestic inflation target and the inflation forecast of Colombia’s main trading partners.44
56. Despite the explicit announcement of an inflation objective, a number of analysts have pointed out that the central bank often gave priority to other objectives, principally the targets for output, at the expense of its inflation goals (Gómez et al., 2000). As can be seen in the comparison of inflation outcomes and the stated objectives of policy presented in Figure 1, before 1999 the inflation objectives were rarely achieved. In addition, the announcement of multiple intermediate targets (base money and the nominal exchange rate) led to confusion among market agents about which target represented the constraint for monetary policy. While the monetary authorities maintained that the priority intermediate target was the monetary aggregate, the market increasingly considered the nominal exchange rate to be the effective target. During the late 1990s the monetary authorities devalued the exchange rate band and widened it to provide more flexibility and resolve the conflict between these intermediate targets. However, in the face of strong persistent capital outflows during 1999 the exchange rate band was abandoned, and the peso was allowed to float.
Colombia: Actual Inflation and Announced Inflation Objectives, 1990–2000
Citation: IMF Staff Country Reports 2001, 068; 10.5089/9781451808834.002.A004
Sources: Dario Uribe et al. (1999); and Banco de la Republica.Colombia: Actual Inflation and Announced Inflation Objectives, 1990–2000
Citation: IMF Staff Country Reports 2001, 068; 10.5089/9781451808834.002.A004
Sources: Dario Uribe et al. (1999); and Banco de la Republica.Colombia: Actual Inflation and Announced Inflation Objectives, 1990–2000
Citation: IMF Staff Country Reports 2001, 068; 10.5089/9781451808834.002.A004
Sources: Dario Uribe et al. (1999); and Banco de la Republica.57. One of the results of the persistent and relatively high inflation that prevailed during the 1990s was that it became imbedded in the institutional structure of the economy. Wages, pensions, taxes, mortgage payments and some financial instruments were formally indexed to inflation (Darío Uribe et al., 1999), increasing the cost of lowering inflation and eroding the credibility of the central bank’s inflation objectives. It was not until the crisis of 1999, when real GDP fell by 4.3 percent due to a rapid decline in asset prices and large increases in real interest rates, that inflation fell below the target of 15 percent to single digits for the first time since the 1970s. This recession and the decline in inflation may have weakened some of the backward indexation mechanisms in the economy and set the stage for the implementation of inflation targeting.45
C. The Implementation of Inflation Targeting
58. In September 2000, as part of its quarterly report on inflation, the Banco de la República published the new guidelines for incorporating inflation targeting into its operations (Banco de la República, 2000). Many of the institutional elements of inflation targeting have been in place for some time, and with this policy statement the central bank took steps toward implementation of the operational aspects of inflation targeting.
Institutional framework
Central bank legal framework
59. As mentioned above, the legal framework for central bank operation of inflation targeting was put in place in Colombia in 1991 and 1992. Under the constitution and subsequent laws the central bank has complete instrument independence and a mandate to pursue price stability, and financing of the government deficit is limited to cases in which the board of directors of the central bank votes unanimously in favor.
Design of the inflation target
60. The annual rate of CPI inflation (which includes volatile prices of energy and agricultural products) is used as the measure of inflation to be targeted. The central bank has chosen this more volatile price index, rather than some measure of core inflation, because it is widely understood by the public, and because prices, wages and financial contracts have been linked to this “headline” index. The CPI has also been chosen as the target in other emerging market countries that have adopted inflation targeting, where the objective is to reduce inflation and directly influence inflationary expectations. In most industrial countries the target is chosen in terms of core inflation and the objective is to maintain inflation at its current level (IMF 2000).
The target horizon
61. The central bank has been mandated by law to announce a yearly target for inflation since the early 1990s. In its recent statement it announced targets for more than one year in advance for the first time. The target for 2001 is 8 percent while for 2002 it is 6 percent. These targets are consistent with the history of gradualism in Colombia that seeks to limit the costs of reducing inflation. The multiyear target follows from the central bank’s recognition that there are long lags between the use of monetary policy instruments and their effect on inflation (typically estimated at six to eight quarters—see below).
Point target or target range
62. The inflation targets have been defined in terms of points rather than ranges, because these are thought to provide a better guide to inflationary expectations and communicate a higher degree of commitment by the monetary authorities to the inflation target (Darío Uribe et al., 1999). Most countries have defined their target in terms of ranges, given the difficulties associated with hitting point targets (IMF 2000).46
Accountability and transparency
63. In addition to announcing yearly targets for the inflation rate, the central bank also announces the target ranges for monetary aggregates which it continues to use as indicators of the stance of monetary policy. Each month the central bank also publishes its inflation forecasts and the observed outcomes of inflation in press releases, public pronouncements and monthly inflation reports. The central bank releases a quarterly inflation report which contains information on policy, on all the relevant information the central bank collects to measure inflation, forecasts inflation outcomes and measures inflationary expectations. In addition, twice a year the board of directors of the central bank presents a report to congress on economic developments and its policy position.
Operational issues: conduct of monetary policy
Policy implementation
64. The behavior of monetary aggregates, especially base money, continues to play an important part in the conduct of monetary policy. For this reason the central bank will establish a reference level for the monetary base which it considers to be consistent with the inflation target, the projected growth of real GDP and any change in the velocity of money. Under normal circumstances, strong deviations of the monetary aggregate from its reference level would signal an increased risk of not attaining the inflation target. If base money differs significantly from its reference level for a period of two weeks or more, the board of directors will take policy measures to correct the level of the base money or will explain publicly why no measures have been taken.47 On a routine basis, the board of directors of the central bank will also evaluate the reference level for base money and can modify it if there are solid technical reasons to do so, always with the aim of achieving its inflation target (Banco de la República, 2000). This was done in July 2000 when base money grew faster than indicated by its band. The authorities considered that a permanent shift in the demand for base money (mostly currency) had taken place, related to the introduction of a financial transaction tax, and thus the upward shift of the base money corridor was not inflationary.
65. Under the floating exchange rate regime, the central bank can intervene in the exchange rate market only in a limited form and under very specific circumstances. First, for the purpose of accumulating reserves it can sell a limited amount of put options for foreign exchange to operators in the market (giving them the right to sell foreign exchange to the central bank). These options can be exercised if the reference exchange rate on any particular day during the month after the auction is more appreciated than its 20 working-day moving average. Second, for the purposes of curbing volatility in the exchange rate, the central bank can sell put and call options on foreign exchange which can be exercised if the reference exchange rate on any particular day is more than 5 percent above or below its 20 working-day moving average. In practice, the central bank has not intervened in the market to curb volatility since the exchange rate was floated in 1999.
Inflation forecasting
66. Aside from monitoring monetary aggregates and the exchange rate, the board of directors of the central bank examines a broad range of indicators for inflation, including aggregate supply and demand, salaries and wages, employment, capacity utilization, the stance of fiscal policy, the international economic context, and the results of a quarterly survey on inflationary expectations. In addition, the board of directors uses a number of inflation forecasts produced with time series and linear regression models. Two time-series models are used: an autoregressive integrated moving average (ARIMA) model and a smooth transition regression (STR) model. The linear regression models are intended to capture the effects of different determinants of consumer price inflation, including the output gap and devaluation (Phillips curve model), food price shocks (relative price of food model), and growth in the money supply (expected inflation model). These models are used to produce a consensus point forecast for inflation at different time horizons from less than six months to up to two years.
Policy transmission channels
67. There is still some uncertainty in Colombia about the transmission mechanisms from changes in policy variables (particularly the interest rate), to their effect on the real economy and ultimately on inflation. Research is underway at the central bank to clarify the transmission mechanisms and allow a prospective approach to the analysis of inflation, as opposed to the retrospective models mentioned above. In particular, the central bank is working toward the implementation of a model of the transmission mechanism similar to the one used in the Bank of England. This model uses a forward looking approach and includes regular Phillips curve and aggregate demand equations together with a policy rule equation intended to link interest rates to inflation. However, it does not include some transmission mechanisms that might be important in Colombia, such as the effects of changes in fiscal policy or in the external economic environment, as well as the effects of changes in the exchange rate. The model is currently being tested and modified, but is not yet being used in the definition of monetary policy.
68. Existing research has focused on three main transmission channels from interest rates to inflation (Figure 2). The first is the channel that relates changes in interest rates to changes in inflation through changes in aggregate demand. This is the strongest channel in Colombia, as one might expect in an economy that, although open in its policy stance, is still relatively closed in terms of the ratio of imports to GDP.48 However, this channel takes effect with long lags, typically of 18 to 24 months, which makes it less useful as a method to control inflation in the shorter term.
Transmission Mechanisms of Monetary Policy
Citation: IMF Staff Country Reports 2001, 068; 10.5089/9781451808834.002.A004
Sources: Dario Uribe et al. 1999; Gómez et al. 2000.Transmission Mechanisms of Monetary Policy
Citation: IMF Staff Country Reports 2001, 068; 10.5089/9781451808834.002.A004
Sources: Dario Uribe et al. 1999; Gómez et al. 2000.Transmission Mechanisms of Monetary Policy
Citation: IMF Staff Country Reports 2001, 068; 10.5089/9781451808834.002.A004
Sources: Dario Uribe et al. 1999; Gómez et al. 2000.69. The second channel relates interest rates to inflation through the direct effect of changes in the nominal exchange rate. An increase in interest rates leads to a nominal appreciation which leads to a decline in the domestic price of imports and hence inflation. This channel takes effect quickly (typically with a lag of two to four months), but it is not very potent because the pass-through from the domestic price of imports to CPI inflation is only partial (about 23 percent). Hence the use of this channel implies considerable volatility in the exchange rate and interest rates. Previous research has estimated that a one percent decline in CPI inflation requires a nominal exchange rate appreciation of about 11 percent (Darío Uribe et al., 1999). In the long-run, the effect of changes in the domestic price of imported inputs on inflation is very small.
70. The third channel relates interest rates to inflation through changes in the real exchange rate. Change in the nominal exchange rate lead to changes in the real exchange rate which affect aggregate demand and inflation. This channel has been estimated to be very weak and to take effect only after very long lags (Darío Uribe et al., 1999).
71. This research provides a useful first step in the investigation of transmission policies for inflation targeting. However, there are inherent uncertainties in the transmission mechanisms due to recent changes in the exchange rate regime, leading to instability in the structural relationships presented in these models. The prospects of changes in these structural relationships implies that research will have to be ongoing to continue to refine the links between policies and outcomes. Experience in other emerging market economies indicates that as inflation declines the structural relationships become more stable and the implementation of inflation targeting is facilitated (IMF, 2000).
D. Conclusion
72. Colombia has most of the institutional structures in place to practice inflation targeting. As outlined above, most of the challenges lie in the implementation, and the central bank is sharpening its knowledge of the transmission mechanisms of monetary policy and improving the framework for forecasting inflation to implement policies that will ensure the achievement of the inflation target. At present, none of the transmission mechanisms identified reveal a robust link between the instruments of monetary policy and the inflation target. This could be a problem of econometric estimation resulting from the fact recent changes in the economy make the identification of clear structural relations difficult. A longer experience with inflation targeting may be necessary to determine the best instruments to achieve the inflation targets.
73. Identifying the transmission mechanisms of monetary policy will also be particularly important in determining the response of monetary policy to internal or external shocks that may put the inflation target in question. Prompt action in the face of external shocks and the announcement of the central bank’s policies, and the reasons for its actions, will be necessary to maintain the credibility in its inflation target.
74. The economic environment in which inflation targeting is being implemented may present another challenge. In particular, one of the preconditions for the successful application of inflation targeting in both developed and developing countries is the absence of fiscal dominance and the existence of a healthy financial sector. While the authorities have made important strides in fiscal adjustment recently, these efforts will have to be maintained to ensure a favorable economic environment for the reduction of inflation. In addition, although there has been some recent strengthening of the financial sector, there are still financial institutions that remain weak, and this may pose a challenge in the conduct of fiscal and monetary policy. Finally, the successful implementation of inflation targeting will facilitate the elimination of backward indexation mechanisms or their replacement with forward looking indexation. This will be facilitated by the achievement of the inflation targets which will strengthen further the credibility of the central bank.
References
Banco de la República de Colombia, 2000, Informe Sobre Inflación: septiembre de 2000.
Darío Uribe, Javier Gómez José, and Hernando Vargas, 1999, Strategic and Operational Issues in Adopting Inflation Targeting in Colombia. Paper presented at the Inflation Targeting Seminar, Cartagena de Indias, Colombia, November 1999.
Gómez, Javier and Manuel Julio, Juan 2000, Transmission Mechanisms and Inflation Targeting: The Case of Colombia's Disinflation. Borradores de Economía, Banco de la República de Colombia.
International Monetary Fund, 2000, Adopting Inflation Targeting: Practical Issues for Emerging Market Countries. Occasional Paper No. 202 (Washington: International Monetary Fund).
Mishkin, Frederick S., and Adam S. Posen, 1997; “Inflation Targeting: Lessons for Four Countries.” Federal Reserve Bank of New York, Economic Policy Review, Vol. 3 No. 3, August, 1997.
Mishkin, Frederick S., and Miguel A. Savastano, 2000; “Monetary Policy Strategies for Latin America.” Paper prepared for the Interamerican Seminar on Economics, Buenos Aires, December 1999.
Svensson, Lars E. O., 1998; “Open-Economy Inflation Targeting” NBER working paper No. 6545, National Bureau of Economic Research, Cambridge MA.
Prepared by Geoffrey Bannister.
In practice, the path for the monetary base was set as an intermediate target for inflation and the path for the exchange rate was adjusted to eliminate the discrepancy between international inflation and the inflation objective of the government’s program (Darío Uribe et al., 1999).
The industrial countries include New Zealand, Canada, Sweden, Finland, The United Kingdom, Australia, and Spain. The emerging market countries include Israel, Czech Republic, Poland, South Africa, Brazil, and Chile.
Before 1994 the exchange rate regime was kept to a crawling peg system which had been in place since the late 1960s.
A judgment by the constitutional court in October 2000 mandating that wage increases in the nonfinancial public sector be indexed to past inflation may put these institutional gains in doubt if such indexing spreads to the rest of the public sector and the private sector.
Use of the headline CPI increases the likelihood of not making the targets directly. Similarly, the use of a point instead of a band increases the likelihood of not achieving the point target. This will require much more communication of the central bank with the public about why the point target is missed in the case of shocks.
In practice intervention takes place through open market operations that affect the short-term interbank interest rate.
The ratio of imports of goods and services to GDP on average between 1995 and 2000 was about 17 percent, below that of many countries in Latin America.
