MONETARY AND EXCHANGE RATE POLICIES IN COLOMBIA (1991-2002)

1. MONETARY AND EXCHANGE RATE POLICIES IN COLOMBIA (1991-2002) By: Sergio Clavijo November 2003 Board of Directors Central Bank of Colombia

2. “The only way [the FED and the Bank of England] affect inflation is by changing the amount of high-powered money…… The difference between the two approaches is in the way they choose to describe their operations to the public, not in the actual operating procedures”. Milton Friedman (2002) “Interview” Quarterly Journal of Central Banking (August).

3. Some History: • Flotation of the peso/dollar was adopted in September 1999, as a result of the Asian, Russian, and Brazilian crises. • Formal “inflation targeting” was announced in October 2000. • The stance of monetary policy is transmitted through the repo-rate, within a framework of “lombard rates”.

4. Consolidation of a trinity framework: • Flexible exchange rate; • Inflation targeting; and • Monetary policy rule (Taylor, 2001).

5. Preliminary Results: • Inflation has stabilized around 7%, completing four consecutive years of one digit inflation in Colombia. • Remarkable for a country with the most persistent moderate-inflation over the previous three decades, average inflation of 22% (Dornbusch and Fischer, 1991). • Real exchange rate has depreciated by 15-20% during 1999-2003.

6. Systemic Risks? • Housing crises exploded in 1998. • “Last resort” money avoided contagion of the financial system. • Cost of the crises is 4-6% of GDP over the period 1998-2007.

7. Institutional Framework: • Constitutional mandate of the CB is hierarchical since 1991: • Pursue low and stable inflation, but • In line with government development plan, which targets higher growth and employment. • The BdR has only instrumental independence.

8. Institutional Arrangements Banco de la República (Colombia) BdR Federal Reserve Bank (USA)FED Objectives Hierarchical Dual Board Members Seven (Including the Minister of Finance) Twelve for the FOMC. Seven for the “Discount Window” Strategy “Inflation Targeting” (Explicit) “Inflation Targeting” (Implicit)

9. Institutional Arrangements Banco de la República (Colombia) BdR Federal Reserve Bank (USA) FED Monetary Instruments: Central: Reference Rates Limiting Rates Secondary: Aggregates Support: Treasury Exchange Rates: Regime Instruments Crawling Bands / Flotation Options: “puts” and “calls” Flotation Intervention thru Treasury REPO and Reverse REPO Lombard Rates-Discount Window Monetary Corridors / Reference Lines (un- announced) Semi-Automatic REPO (Fed.FundsRate) Discount Window Banking Reserves (un-announced) Automatic

10. We will argue: • In favor of adopting “operational inflation ranges”. • In favor of foreign exchange “options” as a way to confront capital markets turbulence.

11. Table 1: Inflation, Unemployment and Growth in Colombia

12. Conclusion: • The 1998-2002 episode of “opportunistic dis-inflation”: a chance for reducing financial and wage indexation. • Orphanides and Wilcox (2002, Int. Fin.) argue that if: Phillips Curve: Π = Πe + α y + s Where y = Log Y - Log Y * and “s”: Observable Shock Inherited Inflation (Intermediate Target): Π = λ Πo 0 ≤ λ < 1 Loss Function: La = ( Π – Π)2 + γ y2 + δ | y | 1. Under δ = 0 and λ = 0 (meaning Πo = 0), Conventional optimal result. 2. But under ( δ, λ ) > 0 (meaning Πo > 0), Opportunistic strategy is optimal: Set output at potential whenever the: A. Policy Makers care about output deviations (larger δ) B. Smaller reward in disinflation in return for maintaining outp-gap (α ) C. Closer is inflation to intermediate gap (Πe + s – Π ≈ 0 )

13. The Board moved from inflation point-targets (1991-2002) to range-targets (2003-2005). • Compatible with inflation targeting and operational ranges (+/- 2% since 2001 within the IMF program). • Uncertainty increases as inflation converges to the long-term 3%; excessive disinflation (1999-2000), or excessive inflation (I-2003), should be avoided.

15. New Monetary Policy and Exchange Rate Flotation in Colombia Four main changes: a) Multi-annual Inflation Targets. b) Macro Global Assessment. c) Signaling via interest rates. d) Fx-Options: “put” to increase NIR and “call” to decrease NIR

17. Foreign Exchange Options I. “Put” Options to Buy NIR Colombia (1999-2002) Mexico (1995-2001) Trigger Rule Spot < Spot(MA20Days) Spot < Spot(MA20Days) Amount Offered in Auction US$ 30 – US$ 200 US$ 250 Cumulative Amount Exerted US$ 1,400 US$12,000 Net Internat. Reserves (NIR) US$ 10,840 US$ 34,000 Amount Exerted / NIR 11.3 % 35 % NIR / Amortization’s Due 1.0 1.2

18. Colombia (1999-2003) Mexico (1995-2001) Trigger Rule Spot > Spot(MA20Days) ------- Amount Offered in Auction US$200 + 200 = 400 (or up to US$1 billion) ------- Cumulative Amount Exerted US$ 145 + 200 = 345 ------- Amount Exerted / NIR 3.3 % ------- II. “Call” Options to Sell NIR

19. Colombia (1999-2002) Mexico (1995-2001) Trigger Rule Spot +/- 4 % of Spot(MA20Days) Spot > 2% of Spot t-1 Amount Offered in Auction US$ 180 US$ 200 Cumulative Amount Exerted US$ 414 US$ 1,950 Exerted Options / NIR 3.8 % 5,7 % III. Options to Control Volatility

20. Central Bank Reaction Functions:The Case of the FED Interest Rate Rules Theoretical Models Estimations 1. Basic Taylor Rule i = r* - 0.5 * + 1.5  + 0.5 y 2. Generalized Taylor Rule i = k + g  + g y y i = 0.63 + 1.7  + 0.8 y +  3. Optimal Taylor Rule i = 2.21 + 2.8  + 1.6 y +  4. Optimal Dynamic i = (1-)(k +g  +g y y)+ i –1 i = 2.21 + 2.8  + 1.8 y +  5. Optimal Lagged i = k + g   + g y y-1 i = 2.21 + 2.5  + 1.6 y + 

21. Central Bank Reaction Functions:The Case of the BdR(Dependent Variable: Interbank Interest Rate)