Sticking to the Target

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Inflation-targeting adopted since 1990 generally reduced inflation and inflation volatility in countries that implemented it.
In several emerging market economies, inflation targeting shifted procyclical monetary policies into countercyclical action, contributing to GDP growth stabilization.
Colombia adopted inflation targeting in 1999 after three decades of stable but stubbornly high inflation.

Before 1999:
- Central bank faced complex indexation mechanisms perpetuating inflation.
- Exchange rate was used as the nominal anchor amid relatively high inflation and a volatile balance of payments, forcing procyclical monetary responses.
After adopting inflation targeting:
- Authorities allowed the exchange rate to fluctuate and used the inflation target as the main nominal anchor.
- Monetary responses to major shocks:
- Global financial crisis in 2007–09: allowed depreciation while relying on inflation target credibility.
- COVID-19 shock in 2020: similar approach of exchange rate flexibility and inflation-target anchoring.
- 2014–16 inflationary shock:
- Causes: drop in terms of trade after oil price collapse, severe drought, 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 returned to the 3 percent target years later without a major sacrifice in output.
- Credibility of monetary policy and stability of long-term inflation expectations were instrumental.

Since 2021, inflation-targeting regimes have faced extreme challenges; credibility in keeping inflation close to target has not held since 2021.
Colombia specifics:
- Inflation rose from less than 2 percent in 2020 to 13.1 percent in 2022, the highest level since inflation targeting was adopted.
- Food prices rose at a yearly rate of nearly 28 percent in 2022 due to domestic and international supply shocks.
- GDP growth: more than 10 percent in 2021 and 8 percent in 2022.
- Current account deficit: widening and close to a historical record in 2022.
- Core inflation (excluding food and government-regulated prices) went from 2.5 percent in 2021 to 9.5 percent in 2022.
- Exchange rate depreciation: by end-2022, the Colombian peso had depreciated 38 percent compared with early 2021.
- Minimum wage increases:
- 2022: raised by 10 percent.
- 2023: raised by 16 percent.
- These increases were well above headline inflation and contributed to higher production costs and a wage-price spiral.
- Fiscal context: fiscal deficits were much larger than regional peers over the past two years, worsening investors’ country-risk perception.

Monetary tightening:
- Banco de la República raised the policy interest rate from 1.75 percent in September 2021 to 12.75 percent in January this year.
Communication challenges:
- Large, protracted inflationary shocks require a long period of convergence to the inflation target that must be explained to the public.
- Tradeoffs:
- Too fast a convergence can be very costly in terms of output and employment.
- Too long a convergence risks de-anchoring inflation expectations.
- Central bank commitment:
- Tightening process is stated as "not over."
- 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 the desired convergence path.

Inflation trajectory and credibility:
- Inflation is expected to decrease fast by historical standards but will probably be above its target rate for the longest period since the inflation-targeting regime was introduced.
- Maintaining the credibility of the target as the main nominal anchor will be more difficult.
Growth outlook:
- Expecting a sharp deceleration of economic activity that would shrink GDP growth to a meager 0.2 percent in 2023.
- Drivers of slowdown: tighter global financial conditions, slower growth in trading partners, and contractionary domestic monetary policy needed to guarantee inflation convergence.
Policy stance and recommendation:
- These challenges are not an argument against inflation targeting; they reinforce the need to strengthen its anchoring role.
- The central bank should pursue a contractionary monetary policy at the current juncture to demonstrate commitment to an explicit and credible inflation target.
- Inflation targeting coupled with a floating exchange rate has helped Colombia confront shocks in ways not possible before; enhancing credibility remains the preferred path through challenging times.

Sticking to the Target, LEONARDO VILLAR, March 2023 (F&D Magazine).

F&D March 2023: Emerging Market Perspectives; Sticking to the Target
- F&D March 2023: Emerging Market Perspectives; Sticking to the Target (Markdown version)
- F&D March 2023: Emerging Market Perspectives; Sticking to the Target (PDF)