Itaú BBA - COLOMBIA – Monetary Policy Report: Low-for-long rates

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COLOMBIA – Monetary Policy Report: Low-for-long rates

August 4, 2020

An expansionary monetary policy stance is justified by the possibility of a 10% GDP contraction

In the central bank’s 2Q20 monetary policy report, the technical staff forecasts a deeper GDP contraction, further containing inflationary pressures that calls for a prolonged period of low rates to aid the recovery. In particular, the research team’s outlook for the policy rate (for 2020) is not too distinct to that held by analysts in the July survey, meaning the easing cycle is likely near its conclusion. The board unanimously chose to cut the policy rate by 25-bps to 2.25% in July, while the median analyst expectation is for the rate to reach 2.0%. Thereafter, the technical team sees rates remaining below expectations by analysts (in the survey a normalization process would start during 2H21, taking the rate to 2.75% by yearend and 3.0% by 1H22). According to the report, upcoming moves would be determined by the evolution of the crisis, reinforcing a data-dependent approach that was signaled in the July meeting.

On the global front, uncertainty remains elevated and risks tilt to a slower recovery. Low oil prices, weak trade partner growth (seen shrinking between 6.0% and 11%), and the sharp income decline from tourism and remittances are viewed as key factors that would unfavorably affect external accounts. Nevertheless, weak imports on the back of downbeat internal demand and a weaker Colombian peso would lead to a current account deficit of between 2% and 5% of GDP this year, from the 4.3% recorded last year. Meanwhile, favorable financing is still expected through FDI and benefiting from improving global financing conditions. Additionally, public indebtedness would become an important source of external borrowing.

Colombian activity could contract by up to 10% this year (+3.3% last year), justifying the expansionary stance for monetary policy. In an acknowledgment to the current state of uncertainty, the updated scenario of the central bank continues to incorporate wide forecast ranges. The technical staff believes the activity contraction could be between 6.0% and 10.0% this year, with -8.5% as the most likely scenario (revised from a -7% to -2% range in April). For 2021, economic growth is expected at 4.1% (in a range between 3.0% and 8.0%). The central bank notes that the pace of the activity recovery would depend on evolution of the pandemic (lockdown duration and occurrence of a second wave). To date, the impact on the labor market has been significant, leading to historical high unemployment (unemployment rate is seen to average between 16.5% and 19% this year), and the recovery is expected to be slow. Overall, the negative output gap is expected to widen drastically to between 5.0% and 7.0% on average during 2020 (0.8% in 2019; 3%-7% expected in April), and to narrow to between 2.0% and 5.0% in 2021.

The internal demand collapse and tax relief measures would keep inflationary pressures contained. Inflation is seen ending the year within a 1% to 2% range (previously was seen between 1.0% and 3.0%; 3.8% in 2019). Additionally, core inflationary pressure is milder than previously expected (1%-2% range; 1%-3% previously) as private consumption falters and labor costs recede. For 2021, headline inflation is expected to pick up to between 2.0% and 3.0%, with 2.3% the most likely outcome. 

Liquidity measures and lower interest rates have contributed to financial markets stability. The report notes that monetary policy has been transmitted through to the market. As activity falters and the labor market loosens, credit growth dynamics started to moderate. Meanwhile, the country risk premium would remain elevated due to the challenging external scenario. 

We expect the monetary easing cycle to conclude in coming months with a final 25-bp rate cut to 2.0%. While the drastic effect of the pandemic on the Colombian economy could justify even more monetary easing (the ex-ante real rate is only slightly negative), for now some members within the board appear cautious about capital flight risks and the possibility of rising of inflation expectations as tax relief measures expire. The next monetary policy decision will take place on August 31.

Miguel Ricaurte
Carolina Monzón

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