Report of the Board of Directors to the Congress of Colombia, July 2023

Las opiniones contenidas en el presente documento son responsabilidad exclusiva de los autores y no comprometen al Banco de la República ni a su Junta Directiva.

The opinions contained in this document are the sole responsibility of the author and do not commit Banco de la República or its Board of Directors.



Introduction The Colombian economy continued to make progress in the adjustment process required to correct macroeconomic imbalances and control the inflationary pressure that had accumulated during the first half of 2023 from the various supply shocks and rapid expansion of demand during 2021 and 2022, which exceeded the economy’s potential growth. The ongoing economic adjustment has been made possible by the moderation of domestic demand growth and the gradual unwinding of the supply shocks that raised production costs. Domestic demand began to slow down in the last few months of 2022 and contracted -0.2% in the first quarter of this year due to slower growth in household consumption and a fall in gross capital formation. Lower international prices for raw materials, the gradual normalization of supply chains, and the appreciation of the exchange rate, in turn, have contributed to dissipate supply shocks. This has been reflected in a decrease in annual producer price inflation from a level of 19.2% at the end of 2022 to 4.7% in June 2023.1 The sluggishness of domestic demand has been reflected in a progressive slowdown in economic activity. Thus, the GDP registered an annual growth of 3.0% in the first quarter of 2023, a rate equivalent to one third of the average annual growth noted during the first three quarters of 2022 (9.1%). According to the economic monitoring indicator (EMI) prepared by DANE, this loss of strength continued in April and May as variations in this indicator of -0.8% and 0.6%, respectively, were registered compared to the same months in 2022. These results were lower than those seen in March (1.4%) in the seasonally and calendar-adjusted EMI series. This suggests that GDP growth will continue to decline in the second quarter and is consistent with the technical staff’s forecast that GDP growth will be slightly below 1.0% for 2023. In spite of the ongoing economic slowdown, the labor market continues to show strength as can be deduced from the continuous decline in the unemployment rate in the national aggregate up to the moving quarter ended in May (10.4%). This is its lowest value since the beginning of the covid-19 pandemic.2 The slowdown in economic activity was, in part, expected to result from the restrictive monetary policy adopted by Banco de la República to control inflationary pressure. A less expansionary fiscal policy than in 2022 may also be contributing to the lower economic activity based on the forecasts presented in the 2023 Medium-Term Fiscal Framework (MTPF-23). Added to this was a slowdown in foreign demand that was relevant for the country due to the lower growth of our trading partners in an international context of high monetary policy interest rates, inflation rates that exceeded their targets, and high uncertainty generated by the prolongation of Russia’s invasion of Ukraine. The Board of Directors of Banco de la República (BDBR) has been reiterating the need to proceed with this adjustment process in its various communications in order to achieve a gradual return of inflation to the 3.0% target, correct macroeconomic imbalances, and ensure the sustainability of economic growth in the long term. The constitutional responsibility that falls on Banco de la República, which was emphasized in the last Report to Congress, requires maintaining low and stable inflation in line with economic policy in general so as to support sustainable economic growth and a bankable foreign balance. Monetary policy decisions have been adopted with the support of the solid institutional and technical basis that supports the inflation targeting regime based on the experience accumulated over more than two decades by the Central Bank. The specific motives that the BDBR has had for undertaking a monetary tightening process and the strongest ones since Banco de la República adopted the inflation targeting strategy have been complex and diverse in nature. Inflationary pressure initially came from foreign and domestic supply shocks that pushed the costs and prices of food and other consumer products up. Added to this was pressure from the exchange rate. These shocks led to an increase in inflation expectations, and this triggered a process of price indexation which was exacerbated by the excess demand that emerged in 2022. The monetary policy response sought to reduce excess demand, contain the rise in expectations, and limit the effects of price indexing by increasing interest rates. All of this creates the right conditions to allow inflation to begin to decline as the supply shocks subside and thereby alleviate cost pressure. This is a process that is being accomplished albeit with some delay, but which, given the time that the monetary policy has been in place, has already begun to produce results as shown by the recent decline in the inflation rate and the downward revision of expectations for it at different periods. In accordance with the constitutional mandate to ensure coordination of monetary policy with the general economic policy in addition to mitigating inflationary pressure, the monetary adjustment has been fulfilling the purpose of correcting macroeconomic imbalances that jeopardize the stability of the Colombian economy. With respect to this, there is no doubt that the 7.3% GDP growth in 2022 was outstanding since it was more than double the global growth (3.5%) and far exceeded the expansion of Latin America and the Caribbean (3.9%) based on IMF figures. Such high economic strength brings important gains in well-being, particularly when it reduces unemployment rates as has been the case in Colombia. However, this growth is unsustainable because it is based on a fiscal situation that is largely in deficit and a worrying increase in household indebtedness. This generated an excess of aggregate demand that not only put upward pressure on inflation and expectations for it but also expanded the current account deficit of the balance of payments to historically high levels for several years. The current account deficit went from an already high level of 5.6% of the GDP in 2021 to one of 6.2% of the GDP in 2022 and was one of the highest seen in Colombia. The increase in the foreign imbalance in 2022 occurred in a year in which international crude oil, coal, and coffee prices remained at favorable levels. This contributed to the positive performance of exports. Nevertheless, in order to cover supply shortages, the economy significantly increased its demand for imports thus preventing a reduction in the foreign imbalance. As a result, the Colombian economy resorted to greater foreign indebtedness either as portfolio investment inflows or as direct indebtedness. All this shows how vulnerable the economy is when it maintains a level of spending that significantly exceeds its income. The restrictive monetary policy, together with the increase in the tax burden, has been inducing a progressive adjustment of these imbalances. The slowdown in domestic demand that began in the fourth quarter of 2022 was accompanied by a moderation in household consumption that had grown 3.0% in the first quarter of 2023 compared to a 9.5% increase in 2022. The latter has been reflected in a slowdown in consumer credit which went from growing at a close to 23% rate per annum at the end of the third quarter of the previous year to just under 7.0% per annum in mid-June 2023. If such a rapid expansion of consumer credit had continued, it could have generated an unsustainable situation in terms of households’ creditworthiness. Likewise, gross capital formation, which performed outstandingly well in 2022, began to show adjustments in its main components. The main source of this correction has been investment in machinery and equipment which, in the first quarter of the year, showed declines in both quarterly and annual terms, mainly in the transportation equipment sector. Along with the progress in correcting the macroeconomic imbalances, total inflation broke off the upward trend it had maintained until March 2023. Indeed, after reaching a level of 13.1% at the end of the previous year, total inflation remained stable at around 13.3% during the first three months of 2023, then began to declineas of April and reached 12.1% in June. Food was the item that contributed most to this change in trend since its annual variation went from 27.8% last December to 14.3% in June. This variation has been offset to some extent by the increase in inflation of regulated products due to successive increases in gasoline prices. Core inflation (excluding food and regulated products), in turn, continues to show rigidity as it stood at 10.5% in June and thus reflected price indexation processes. The services sub-basket has been particularly affected by the indexing which has been compounded by labor cost pressures, rising food prices that have put upward pressure on eating out and the high demand for entertainment services. This behavior should gradually diminish as the effects of monetary policy are eventually passed through to the economy, and the downward trend in inflation is reflected in a downward revision in the public’s expectations of price changes. This is in line with the technical staff’s forecasts and the market’s expectations that anticipate declining inflation over the next two years. ________________________________________________________________________________________ 1 This corresponds to the annual change in the domestic supply PPI. 2 At the close of this Report, data was released from the General Integrated Household Survey for June in which the unemployment rate remained stable in its seasonally adjusted measurement of the national aggregate for the quarterly moving average (10.3%) although there was a reduction in the June data. Boxes Box 1 - Recent Changes in the Savings-Investment Balance and its Financing Box 2 - Economic Effects of Indexation and its Prevalence in Colombia Box 3 - Resilience of the Colombian Financial System: Analysis Based on the Recent Period of Banking Stress in the U.S. Box 4 - The Recent Digitization of Payments in Colombia



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