Download Creeping Inflation How much of a concern? What should the

Creeping Inflation
How much of a concern?
What should the response be?
Hernando Vargas
Banco de la República
Colombia
May 2008
How much of a concern?
• Definitely a concern
– Large and persistent relative price shocks
– Some countries face strong demand
pressures
– Remember the 1970´s:
•
•
•
•
Shocks to oil and food prices
CBs kept low real interest rates
Oil and food prices came down, …
… but inflation and inflation expectations did not
WORLD FOOD, OIL AND CONSUMER PRICES
1970-77
250
%
Inflation in Consumer Prices (Righthandside)
%
18
16
Oil Price Inflation (Lefthandside)
200
14
150
12
Food Inflation (Lefthandside)
10
100
8
50
6
4
0
2
Source: IMF.
-50
1970
1971
1972
1973
1974
1975
1976
0
1977
REAL INTEREST RATES 1970-77
%
4
3
2
1
0
-1
-2
-3
-4
-5
1970
1971
United Kingdom
1972
1973
Japan
1974
United States
1975
1976
Average of eight countries*
Source: IMF.
Notes: *Australia, Canada, France, Germany, Italy, United Kingdom, United States and Japan.
1977
How much of a concern?
• Even more a concern in Latin America:
CB credibility may still be questioned and
inflation expectations may not be firmly
anchored around the targets
 The low and stable inflation regime has been
relatively short and has not been consolidated in
some countries (still in a disinflation process)
45%
Chile
México
40%
Perú
Ene-08
Brasil
Ene-07
Colombia
Ene-06
Ene-05
Ene-04
Ene-03
Ene-02
55%
Ene-01
Ene-00
Ene-99
Ene-98
Ene-97
Ene-96
Ene-95
Ene-94
Ene-93
CPI Annual Inflation - Latam
60%
50%
35%
30%
25%
20%
15%
10%
5%
0%
How much of a concern?
• Even more a concern in Latin America:
Indexation mechanisms are still in place. F. ex.
Colombia:
• Minimum wage, public wages (signals for the setting
of other wages)
• Public utilities
• Other services (education)
 Other indexation mechanisms may re-emerge if
high inflation persists (fresh memory of high
inflation)
What should the response be?
• It depends on:
– The degree to which inflation expectations and
price/wage formation are anchored to the inflation
targets
– The current state of the economy and the possible
future scenarios for the “exogenous” variables
• In Colombia: Inflation Targeting  By
construction takes into account those factors
What should the response be?
• In Colombia shocks occurred when:
– The economy was facing strong demand
pressures and rising core inflation
– Monetary policy was already in a tightening
cycle
• This complicated the inflationary situation,
but made it easier to adopt and explain a
restrictive monetary response
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Ene-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Ene-06
Colombia: Output Gap
3,0%
2,5%
2,0%
1,5%
1,0%
0,5%
0,0%
-0,5%
-1,0%
Colombia: CPI Annual Inflation
%
%
4,0
10
9
8
3,5
7
6
5
Core Inflation
Food and Regulated Prices
Mar-08
Ene-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Ene-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
4
Ene-06
3,0
Mar-08
Ene-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Ene-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Ene-06
%
Colombia: CB Overnight Interest Rate
%
10,00
9,00
8,00
7,00
6,00
5,00
What should the response be?
• Why a restrictive response?
In addition to demand pressures and
improving TOT, shocks increased inflation
expectations and pushed up nominal wage
increases
Break-Even Inflation from Government Bonds
6,50%
6,00%
5,50%
5,00%
4,50%
4,00%
1 Year
5 Years
10 Years
Observed Headline Inflation
Abr-08
Ene-08
Oct-07
Jul-07
Abr-07
Ene-07
3,50%
Nominal Wages
Annual Growth
11%
9%
7%
5%
3%
Ene- Feb- Mar- Abr- May- Jun07
07
07
07
07
07
Retail
Jul07
Ago- Sep- Oct- Nov- Dic- Ene- Feb07
07
07
07
07
08
08
Industry
Construction
What should the response be?
• Some issues under discussion in Colombia
1) “The price shocks themselves have a
contractionary effect on income and
expenditure”
Answer: In an IT regime in which the S.T. int.
rate is smoothed, the CB supplies the increase
in nominal money demand derived from the
price shocks  Where is the contractionary
effect of the shocks?
What should the response be?
• Some issues under discussion in Colombia
2) Instruments: “Reserve requirements should be used instead of the
CB interest rate”
Advantages:
- Reinforce transmission mechanism  Colombia 2007
- May induce less capital inflows
- Help sterilize FX intervention
Drawbacks:
- Affect less transmission channels and to a smaller extent
 Concentrate the burden of inflation control on fewer agents
- More uncertain size and timing of the effect on inflation and output
- Less clear a signal to indicate monetary policy stance
- Distortionary tax: Level and volatility are costly in terms of financial
deepening and may induce dangerous “financial innovations”
What should the response be?
Final Comments
• Short / Medium term:
For countries in Latin America, control of
“creeping” inflation is key to pursue
countercyclical monetary policy and allow
flexibility of the exchange rate when external
conditions become less favorable
• Long Term
Indexation mechanisms should be removed as
much as possible when reaching low and stable
levels of inflation