It is the first rate hike by the Central Bank of Colombia this year following cuts that totaled 125 basis points in 2014.
The central bank said sharp rises in the prices of goods that are most affected by a depreciation of the peso were continuing to push up inflation and this may affect the cost of goods and services that are indexed, pushing up inflation expectations.
At the same time, the impact of El Nino has intensified, raising the risk of higher food prices.
Colombia's inflation rate rose to 4.74 percent in August from 4.46 percent in July and inflation expectations have risen to above 4.0 percent.
The central bank targets inflation at a midpoint of 3.0 percent within a range of 2-4 percent.
Colombia's peso has been depreciating in sync with the fall in oil prices since mid-2014 and was trading at 3,072.5 to the U.S. dollar today, down 22.6 percent since the start of the year.
Colombia's economy has been slowing in response to lower demand from machinery investment and transportation equipment but annual growth in the second quarter of 3.0 percent, up from 2.8 percent in the first quarter, was slightly better than expected by the central bank.
For the third quarter, the bank's staff maintained its forecast for growth between 1.8 and 3.4 percent, with 2.8 percent the most likely outcome.
The Central Bank of Colombia issued the following statement:
"The Board of Directors of Banco de la República at today’s meeting decided to increase the benchmark interest rate by 25 bp to 4.75%. The Board took into consideration mainly the following aspects:
- In August, annual consumer inflation rose, reaching 4.74%. The average of the four measures of core inflation (4.46%) increased again, reaching its highest level since June 2009. Analysts’ one and two years inflation expectations are around the top half of the target range, and those embedded in 2, 3 and 5 years public debt bonds are above 4.0%.
- Pass-through of nominal depreciation to consumer prices and the increase in the cost of imported raw materials, as well as the lower dynamics in food supply, explained to a great extent the acceleration of inflation so far this year.
- Pass-through of part of the devaluation of the peso to consumer prices and the greater intensity of El Niño have slowed down convergence of inflation to the target, due to its direct impact on prices and inflation expectations as well as by the probable triggering of indexation mechanisms.
- Figures for global economic activity continue to reflect a weak dynamics of external demand, below the one recorded in 2014. In the United States, the economy would have continued to grow at favorable rates, while the euro zone is recovering slowly. In China, the slowdown continues and its central bank implemented new measures to stimulate the economy. The major economies of Latin America recorded low growths or contractions in their output.
- In the United States, the Federal Reserve decided to maintain its benchmark interest rate unaltered. As for Latin America, the risk premia of the major economies remain at levels higher than those of 2014, and the value of their currencies against the US dollar has been volatile.
- The international price of oil and other commodities exported by Colombia remain at low levels. The fall in the terms of trade recorded throughout the year has deteriorated national income and largely explains the higher level of the exchange rate vis-à-vis the US dollar.
- In Colombia, economic growth in the second quarter (3.0%) was slightly better than projected by the technical staff. Domestic demand slowed down mainly in machinery investment and transportation equipment. Private consumption grew at a slower pace. Both exports and imports fell, but their net contribution to GDP growth was positive. Considering this and with the new information of the third quarter, the technical staff maintained the estimated range for economic growth between 1.8% and 3.4%, with 2.8% as the most likely outcome.
Explanation of the policy decision
- The adjustment of the Colombian economy to the strong income shock derived from the strong fall of the international price of oil has required a substantial depreciation of the peso. This is necessary to reorient sectoral spending and production, leading to adjustment of the country’s external accounts.
- The expectations of an increase in the benchmark interest rates by the US Federal Reserve have generated additional pressures towards depreciation.
- Due to its magnitude, devaluation has raised inflation in consumer prices. However, this shock is considered transitory, as an additional strong and continuous depreciation is not expected. This impact adds to the temporary shocks in food supply at the beginning of the year.
- In the light of the transitory nature of all these shocks, and considering the anchoring of inflation expectations to the target, gradual convergence of inflation was expected in the policy horizon without altering the benchmark interest rate.
- At the same time, a slowdown in the economy was foreseen as a result of the deterioration in the terms of trade. Given the persistence of the less favorable terms of trade and national income, a slowdown in domestic spending was thought to be compatible with sustainability of the country’s external accounts. However, the risk that the slowdown could be excessive was recognized, especially in a context of weak external demand. With the information from the last month, the likelihood of this risk has decreased.
- Under these conditions, the Board of Directors deemed appropriate then to keep interest rates stable at expansionary levels.
- The new information available shows a continuous and higher-than-expected increase in inflation and core inflation indicators, as well as the appearance of signs of possible “unanchoring” of inflation expectations.
- The sharp increases in the prices of goods that are most affected by the depreciation of the peso have continued pressing inflation upwards. Prices of other goods and services also show increasing variations, which may reflect indexation, expectations of higher inflation in the future, or pressures in costs in these sectors. At the same time, El Niño has intensified, increasing the risk of further increases in food and energy prices.
- As mentioned, inflation expectation indicators increased, and those derived from the prices of short and long term public debt are above 4.0%.
- Recent data on growth and economic activity confirm a slowdown in production and expenditure in line with the projections of the Central Bank’s technical staff, compatible with the correction of the country’s external deficit.
- The risk of a lasting increase in inflation and unanchoring of inflation expectations has risen, while the risk of an excessive slowdown in economic activity has not exhibited a noticeable change.
- Under these conditions, given the current expansionary monetary policy stance, the Board of Directors decided to increase by 25 bps Banco de la República’s benchmark interest rate. With the current information, the Board believes that this increase is consistent with the convergence to the inflation target of 3.0%.
- The Board reiterates its commitment to the inflation target and continues to carefully monitor the behavior and projections of economic activity and inflation in the country, as well as that of asset markets and the international situation."