Inflation Targeting in Colombia, 2002–12

Over the last twenty years, nearly thirty countries have adopted inflation-targeting regimes to conduct monetary policy. In addition to the announcement of specific inflation targets, inflation-targeting regimes have been characterized by increased transparency, enhanced communication with the public, and explicit accountability mechanisms. Moreover, their policy strategy is based on setting short-run interest rates rather than on targeting monetary aggregates. In principle, inflation-targeting regimes also increase exchange rate flexibility.

The performance of inflation-targeting regimes has been a matter of extensive research. For instance, Ball and Sheridan and Lin and Ye conclude that in industrialized countries, inflation targeting did not make a difference in inflation and output behavior.¹ The spirit of these conclusions is echoed in two recent surveys on the performance of inflation targeting.² Another line of research on inflation targeting in industrialized countries studies its impact on sacrifice ratios—output losses per point of inflation during monetary-driven disinflations. According to proponents, inflation targeting anchors inflation expectations, and it should thus allow for less costly disinflation processes. While Gonçalves and Carvalho find strong evidence supporting this hypothesis in developed countries, Brito shows that the results are not robust to the inclusion of time effects.³ De Roux and Hofstetter conclude that inflation targeting allows for less costly disinflations even when controlling for time effects, but only if disinflations are slow.⁴ For fast disinflations, it does not yield less costly disinflations.

For developing countries, the evidence is less conclusive. Gonçalves and Salles find that inflation targeting allows for a greater reduction in inflation and lower output volatility, a result confirmed by Lin and Ye.⁵ Brito and Bystedt, however, suggest that the greater inflation reduction came at the expense of poorer output growth.⁶ In the surveys, Walsh concludes that evidence on inflation targeting in developing countries is clearly favorable to the regime, while Ball is more skeptical, calling the outcomes inconclusive.⁷

More recently, de Carvalho Filho shows that during the recent global financial crisis, inflation-targeting nations outperformed non-inflation-targeting nations on several dimensions for both developed and developing economies: their policy response was more aggressive, they allowed the exchange rate to more effectively absorb the shocks, and they recorded a stronger macroeconomic performance (output, industrial production, and unemployment).⁸

The vast empirical literature comparing performance across different monetary regimes stands in contrast to the relatively scant research on the tools, strategies, goals, and dilemmas faced by inflation-targeting central banks, especially in developing countries. While there is good information on the overall comparative performance of these regimes, little information is available on the political economy dimensions, the increasing variety of instruments and goals of inflation-targeting central banks, and the challenges that lie ahead for them.

In this paper, we fill part of this gap by examining the experience of the Central Bank of Colombia (Banco de la República) over the last decade, a period of consolidation and innovation of its inflation-targeting strategy. Colombia is one of five large Latin American economies that have well-established inflation-targeting regimes, along with Brazil, Chile, Mexico, and Peru. All of these countries adopted inflation targeting more than ten years ago, yet their performance, tools, and goals have not been extensively studied. Central banks in the region have used a variety of tools beyond short-run policy interest rates, including liquidity and reserve requirements, credit provisions, capital controls, and interventions in the foreign exchange markets.

We employ several strategies to study these issues. We propose and estimate a small-scale open economy policy model for the Colombian economy. This allows us to pinpoint crucial parameters through which we can study some of the policy trade-offs and policy reactions of the central bank. We also provide narrative and anecdotal evidence for understanding some important episodes, tools, challenges, and trade-offs that marked the first decade of inflation targeting.

Several findings are worth noting. Our model’s estimates suggest that the impact of foreign variables on domestic outcomes is small and often insignificant. The pass-through of...