1. Monetary Policy in Colombia Hernando Vargas Banco de la República April 2005

2. I.Monetary Policy Strategy II.Recent Trends in the Economy III. Monetary and Exchange Rate Policies IV. Is Inflation picking up? V. Is there an Asset Price Bubble?

3. I. Monetary Policy Strategy

4. Inflation Targeting since 1999…. …. with strong FX intervention since 2004

5. II. Recent Trends in the Economy

6. International conditions have favored growth and currency appreciation Terms of trade (Oil, Coal, Coffee etc) External Demand for “non-traditional” exports (Venezuela and the U.S.) Workers´ remittances Low external interest rates and sovereign spreads High FDI

7. Internal conditions have favored growth of output and aggregate demand Low domestic interest rates Improved balance sheets of the financial system, households and firmsImproved balance sheets of the financial system, households and firms Growing business and consumer confidenceGrowing business and consumer confidence Increasing productivity? (imports of capital goods and foreign competition)Increasing productivity? (imports of capital goods and foreign competition)

8. Results: High growth rates of output and aggregate demand

9. Results: Negative output gap possibly closing…. …. Although there is great uncertainty regarding the measures of output gap

10. Results: Strong nominal and real currency appreciation

11. Results: Decreasing inflation on target

12. III. Monetary and Exchange Rate Policies

13. Low short term interest rates and large CB intervention in the FX market (especially since 2004) So far, the signals coming from interest rate policy and FX intervention have been consistent

14. Some features of FX intervention Discretionary intervention since september 2004 (before: “rules-based” auctions of options) No time-frame or amounts are announced No specific level of the exchange rate has been targeted Sterilization – CB has “defended” the short run interest rate: –OMOs –Reductions in REPO loans to banks –Government deposits in the CB –Sales of international reserves to the Government

15. The FX exposure of the Government has been reduced…

16. …But market risk has increased in the financial system (greater reliance on the domestic market) Peso-denominated foreign debt: Attractive but limited option Greater fiscal adjustment + better market risk regulation?

17. Why has the CB maintained low interest rates? IT: Conditional inflation forecasts on target: –Negative output gap –Currency appreciation –Inflation expectations close to targetsInflation expectations close to targets

18. Why has the CB intervened in the FX market? Initially, to restore the level of international reserves after the 2002-2003 episode Later, to protect the “tradable” sectors of the economy from what seemed to be a temporary appreciation: –TOT and external demand reversal (Oil and Venezuela) –Fall in the future volume of oil exported (reserves depletion) –2006: Electoral year

19. However, appreciation has lasted longer than expected… TOT did not fall. In particular, high oil prices have: –Increased the value of exports –Kept high growth rates in Venezuela and Ecuador –Attracted FDI External interest rates and spreads unexpectedly low for an unexpected longer period Strong coal exports and FDI Purchases of Colombian corporations by foreign investors …. Confidence?

20. Has the FX intervention been effective? The Col peso has appreciated… …but less and with lower volatility than other regional currencies since 2005, despite of a larger fall in the Colombian “spreads”….

21. However, it is difficult to extract clear conclusions about the effectiveness of intervention: – Counterfactual? –International comparisons require to control for other effects If appreciation persists, there might be conflicts between FX intervention and the inflation target, especially if the output gap turns positive at a fast rate: –Reduction of the credibility of the IT or the effectiveness of FX intervention –Nevertheless, there is ample scope for sterilization: CB profits > 0 Small interest rate differential

22. IV. Is Inflation picking up?

23. External conditions in 2006-2007 still favor aggregate demand growth and appreciation (or a small depreciation at best) High TOT in 2006 and no strong reversal in 2007 High growth rates of trading partners No strong reversal in capital flows Possibly large FDI inflows (mining) ….Although this scenario is subject to great uncertainty, especially regarding capital flows

24. On the basis of this scenario we forecast a reduction of inflation in 2006 and a rise in 2007…

25. 2006: Appreciation, decline in growth of food prices and some regulated prices 2007: Negative output gap closes, pressures on non- tradable goods prices and on some regulated prices

26. The low initial level of real interest rates and the closure of the output gap (pressure on non- tradable goods prices) will require increases in the interest rates in the future… … However, the timing and the size of such moves will depend on the behavior of the economy. In particular, there is uncertainty on: –The importance of the (one time effect?) increases in productivity and competition. F. ex. many non- tradable sectors still show low or decreasing rates of inflation (expectations or productivity/competition?) –The evolution of the exchange rate: A faster reversal of the spreads or capital flows will probably require faster and larger increases of the interest rates

27. V. Is there an Asset Price Bubble?

28. ….No or not a relevant one Two key macroeconomic variables: …do not show signs of large macro imbalances so far Three key asset prices: Real Estate, Stocks, Public Bonds

29. Real Estate: Not at this point…

33. Real Estate: …but this market must be closely monitored Housing is an important component of households´ assets and mortgage credit may become again significant in households´ debt Recently, banks have reduced significantly the mortgage interest rates

34. Stocks: Large price inceases related, among other things, to foreign purchases of colombian companies

35. Stocks: There may be a “bubble” component…, but it is not macroeconomically important Stocks represent less than 5% of household´s portfolios, … less than 15% of pension funds portfolios, … and less than 5% of bank´s portfolios However, it might be an important indicator of portfolio shifts

36. Domestic Public Bonds: Market risk is a concern, but prices are mostly related to external factors

37. END

38. Workers´ Remittances ◄

39. High FDI (Gross) ◄

40. Low domestic interest rates ◄

41. Improvement of balance sheets of the financial system, households and firms ◄

42. Growing business and consumer confidence ◄

43. Increasing productivity? ◄

44. Inflation expectations close to targets ◄