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Creeping Inflation How much of a concern? What should the response be?

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:

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Creeping Inflation How much of a concern? What should the response be?

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  1. Creeping InflationHow much of a concern?What should the response be? Hernando Vargas Banco de la República Colombia May 2008

  2. 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

  3. WORLD FOOD, OIL AND CONSUMER PRICES 1970-77 Source: IMF.

  4. REAL INTEREST RATES 1970-77 Source: IMF. Notes: *Australia, Canada, France, Germany, Italy, United Kingdom, United States and Japan.

  5. 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)

  6. 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)

  7. 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

  8. 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

  9. 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

  10. 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?

  11. 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”

  12. 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

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