Bancolombia Analysis: Central Bank Responds to Inflationary Challenges with a 50 Basis Point Rate Hike

At its October meeting, the Board of the Central Bank decided by majority to give a 50-bp hike to the repo rate to 5.25%. This adjustment was above our expectation and market consensus, which aimed at a 25-bp increase. In addition, the Bank reactivated auctions of FX call options for the decumulation of foreign exchange reserves to control sharp increases in the exchange rate. Here are the aspects leading to these decisions and our view.

Inflation remains above the target range and expectations have increased. September figures showed that headline annual inflation stood at 5.35%, and the average of the four measures of core inflation reached 4.89%. Similarly, inflation expectations continued to rise. Analysts’ one and two year inflation expectations are at 4.1% and 3.5%, respectively, while those coming from the TES market at 2, 3 and 5 years are above 4%. The Central Bank confirmed that the acceleration in inflation was due to the transfer of exchange rate depreciation to consumer prices and its effect on imported raw materials, which added to the lower dynamics of food supply. Together with a strong El Niño phenomenon this will slow down the convergence of inflation to the target range.

The growth forecast for 2015 was revised upwards. The Bank raised its growth forecast for 2015 from 2.8% to 3%, ranging between 2.4% and 3.4%. This is because Q3 leading indicators reflect more dynamism than previously projected. It’s worth mentioning that the Bank’s 2015 growth estimate is now slightly below our 3.1% estimation for 2015.

Real rates have declined and credit continues to expand. The Board highlighted the depressing effect that rising inflation expectations have on the real levels of the repo rate and lending rates as well as the fact that credit keeps growing above economic activity. However, in the statement there was no mention of the current money market conditions, which have been characterized by higher growth in money demand vs. supply, which has caused a significant increase in borrowing rates among financial intermediaries.

For the Central Bank, inflation expectations have increased and the risk of domestic slowdown has moderated. In view of this and to ensure the convergence of inflation to the target range, the Board decided to increase the repo rate by 50 bps. It’s worth mentioning that our expectation and the consensus of analysts had estimated an increase of 25 bps. However, given the magnitude of the hike the Bank takes a stronger stance and gives more weight to inflation than the economic slowdown on its risk balance.

Auctions for the decumulation of foreign exchange reserves were reactivated. In addition to the monetary policy decision, the Board announced the adoption of a call auction system, “in order to moderate unjustified increases in the exchange rate, which can contribute to the un-anchoring of inflation expectations, and provide liquidity to the exchange market when a significant drop in liquidity occurs. The auction will be held for USD 500M once the FX rate is 7 pps above its 20-day moving average. The options are valid for one month from the date of the auction and its exercise is subject the fulfillment of the same condition.”

It’s worth noting that the conditions for holding these auctions occurred only twice in the last year (mid-December and late August). Even more, since 2000 the total number of times that these conditions had been met is only 7, which shows that the auction of these options would only be feasible in a situation of a very sharp increase in the US Dollar against the Colombian peso.

It’s also worth mentioning that a possible decumulation of foreign exchange reserves through the auction and execution of these options could add additional pressures to the liquidity of the money market. In that sense, should the issuance of these options realize an expansion mechanism to compensate the legal currency resources that agents would deliver the Bank will be key.

Figure 1. FX Rate Evolution, 20-Day Moving Average and Occurrence of the Conditions to Auction FX Call Options

Source: Grupo Bancolombia, Central Bank.

What’s our take and perspectives on policy?

With its monetary and exchange rate decisions on Friday, the Bank hinted important signals about its current reading of the economy. The most important one is that a sharp adjustment in both domestic activity and external imbalances this year has been ruled out. This situation brings significant risks, to which a less expansionary monetary policy is the right answer:

• A milder downturn complicates the control of inflation as it keeps the increases in food prices, the transfer of the devaluation and the indexation mechanisms from having a strong counterweight through lower aggregate demand.

• An external imbalance that is not significantly adjusted is reflected in the current account deficit in 2015 standing at an estimated level of 6.2% of GDP (similar to our forecast). In an environment of lower foreign capital flows, this not only makes a decumulation of foreign exchange reserves inevitably but also keeps the Colombian economy vulnerable to global uncertainty. The call auction is precisely an answer to these two circumstances.

• A soft landing for the economy could lead the growth credit rates to remain high, which could carry risks to financial stability in the medium term.

October’s rate decision was unexpected but not surprising. While we’re expecting an upward adjustment in the benchmark rate of only 25 bps, given the deterioration and inflation risks mentioned the movement taken on Friday is understandable. Indeed, during the time the inflation targeting policy has operated rate movements over 25 bps have been infrequent. Therefore, the latest decision shows the great concern of the Bank with the recent evolution of inflation and its determination to help agents’ inflation expectations adjust to the target range again.

As we have argued in previous analyzes, the fact of having begun rate increases several months after inflation began to pick risked having to make sharper further adjustments, and that’s precisely what we’re seeing.

Henceforth, it’ll be crucial to pay attention to the dynamics of agents’ inflation expectations since the course of monetary policy will largely depend on them. Having taken a higher hike than the estimated by agents may be a signal that induces a change in the trend of said expectations. However, it should be kept in mind that they respond strongly to movements in actual inflation. Thus, inflation could continue to rise in October to 5.6%, keeping expectations above the target range. In addition, as mentioned in the statement, price indexation mechanisms on high levels of inflation are beginning to operate, and they will do so even more strongly towards to the end of this year and the beginning of the next one (with the revision of salaries and several fees linked to actual inflation).

Faced with the challenge of limiting inflationary expectations in this complex environment, we conclude that increasing the repo rate may not be over yet. To be certain, it will be key to have information such as October CPI, the inflation report to be published by the Bank in the coming days, the results of expectation surveys for November and the behavior of implied inflation in the TES curve.

In any case, it should be considered that further increases in the repo rate would imply a risk on growth for 2016 and 2017. Given the lags in monetary policy, any increases the Board were to make in the following months would have an impact on economic activity in 2H16 and during 2017. Since next year we expect a slowdown of production activity to 2.8%, a more restrictive monetary policy would add an additional downside risk to this forecast. Therefore, the proposed course of action would mean that, as soon as inflation returns to the target range, the pace of cuts that the repo rate would experience (which we expect to occur in 2h16) could be faster than the one expected in our baseline scenario. Ultimately, we anticipate a sharp activism from the Central Bank over the next year.

Reprinted with the permission of Grupo Bancolombia

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