## Sticking to the Target

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**Canonical URL:** [Sticking to the Target](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/em-perspectives-villar.pdf)

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### Background: inflation targeting experience
- Inflation targeting first adopted in 1990 and has been "generally successful as a monetary policy strategy."
- Most adopters have reduced inflation and inflation volatility.
- In several emerging market economies, inflation targeting has enabled a shift from procyclical to countercyclical monetary policies, contributing to GDP growth stabilization.
- Before inflation targeting, Colombia relied on indexation mechanisms and the exchange rate as the nominal anchor, which forced procyclical monetary responses to external cycles and shocks.

### Game changer: Colombia’s adoption and outcomes
- Colombia introduced inflation targeting in 1999 after "three decades of stable but stubbornly high inflation."
- Policy changes after adoption:
  - Authorities allowed the exchange rate to fluctuate, using it as a first line of defense against external cycles and shocks.
  - The inflation target became the primary nominal anchor, enabling countercyclical policy during crises.
- Crisis responses:
  - During the global financial crisis in 2007–09 and the COVID-19 shock in 2020, authorities allowed the currency to depreciate while relying on inflation-target credibility.
- 2014–16 shock episode:
  - Simultaneous drop in terms of trade after the oil price collapse, a severe drought, and other supply shocks.
  - Annual nominal depreciation reached 68 percent in 2015.
  - Inflation rose from about 3 percent in mid-2014 to 9 percent in July 2016, then fell back to the 3 percent target years later without a major sacrifice in output.
  - Credibility and relative stability of long-term inflation expectations were instrumental to the adjustment.

### Post-COVID challenges for inflation targeting
- Since 2021, central banks' credibility in keeping inflation close to targets has been tested; "this has not happened since 2021."
- Colombia specifics:
  - Inflation rose from less than 2 percent in 2020 to 13.1 percent in 2022, the highest level since adopting inflation targeting.
  - Food prices rose at a yearly rate of nearly 28 percent in 2022 due to domestic and international supply shocks.
  - Strong aggregate demand recovery contributed: GDP grew by more than 10 percent in 2021 and 8 percent in 2022.
  - Widening current account deficit is close to a historical record despite beneficial terms of trade in 2022.
  - Core inflation (excluding food and government-regulated prices) went from 2.5 percent in 2021 to 9.5 percent in 2022.
  - The Colombian peso depreciated 38 percent by the end of 2022 compared with early 2021.
  - Depreciation is higher than in most other countries in Latin America and coincided with deterioration in investors’ country-risk perception amid larger fiscal deficits than regional peers.
  - Indexation effects: annual minimum wage increases based on observed past inflation contributed to keeping inflation high.
    - Minimum wage increases: 10 percent in 2022 and 16 percent in 2023, both "well above headline inflation," contributing to higher production costs and a wage-price spiral.

### Communication, transparency, and policy reaction
- Monetary policy tightening has been unprecedented:
  - Banco de la República raised the policy interest rate from 1.75 percent in September 2021 to 12.75 percent in January (year implied by context).
- Communication challenges:
  - Large and protracted inflationary shocks require a long period of convergence to the inflation target, which must be explained to the public.
  - Risks: too fast convergence can be very costly in output and employment; too long convergence risks de-anchoring inflation expectations.
- Central bank stance and expectations:
  - The central bank has stated the tightening process "is not over" and is committed to bringing inflation down to its 3 percent target over a two-year period with an acceptable deviation of 1 percentage point.
  - Inflation expectations are "broadly consistent with our desired convergence path."

### Credibility anchor and near-term scenario
- Inflation is expected to decrease fast by historical standards but will probably remain above its target rate "for the longest period since the inflation-targeting regime was introduced," making it harder to maintain credibility of the target as the main nominal anchor.
- Expected macro scenario for 2023:
  - A sharp deceleration of economic activity is expected, shrinking GDP growth to 0.2 percent in 2023.
  - Drivers: tighter global financial conditions, slower growth in trading partners, and a contractionary domestic monetary policy intended to guarantee inflation convergence.

### Policy implications and recommendations
- The post-COVID challenges are not an argument against inflation targeting; rather they:
  - Reinforce the importance of strengthening the anchoring role of the inflation target.
  - Require pursuing a contractionary monetary policy at the current juncture to demonstrate the central bank’s commitment to an explicit and credible inflation target.
- Continued use of inflation targeting coupled with a floating exchange rate has served Colombia well and remains the best path to overcome current challenges by enhancing credibility.

*Source: EMERGING MARKET PERSPECTIVES — Leonardo Villar, governor of Banco de la República (Colombia).*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/em-perspectives-villar.pdf_