Banco de la República's policy strategy seeks to maintain a low and stable inflation rate, as well as to achieve an output level close to its potential. In addition, the Central Bank's policy contributes to preserve financial stability as well as stability of the payments system. The flexibility of the exchange rate is considered primordial to achieve these objectives. Firstly, in a flexible exchange rate regime, the exchange rate operates as an adjustment variable facing the shocks that affect the economy, thus reducing the volatility of economic activity. Secondly, the flexibility of the exchange rate allows for the independent use of the interest rate as an instrument to bring inflation and output to their desired values. Thirdly, flexibility of the exchange rate reduces the incentives to excessive exchange-rate risk by economic agents, which is vital to maintain financial stability.
Despite this, the Central Bank of Colombia, as the exchange rate authority, has the power to intervene in the foreign exchange market. Such intervention does not limit the flexibility of the exchange rate, and it does not intend to set or achieve a specific exchange-rate level; rather, it has other purposes that are compatible with the inflation targeting strategy. Specifically, the Bank's intervention seeks to: (i) increase the level of international reserves in order to reduce external vulnerability and improve the conditions of access to external credit; (ii) mitigate exchange rate movements that do not clearly reflect the behavior of the fundamentals of the economy and which may negatively affect inflation and economic activity; and (iii) moderate rapid and sustained deviations in the exchange rate vis-à-vis its trend in order to avoid a disorganized behavior of the financial markets.
In order to ensure the compatibility of the exchange rate intervention with the inflation targeting strategy, foreign exchange purchases and sales are sterilized as necessary to stabilize the short-term interest rate at the level that the Board of Directors deems consistent with the inflation targets and with the evolution of the output around its natural level. This means that the monetary expansion or contraction generated by the sales or purchases of foreign exchange is offset so that the short-term interest rate does not deviate from level prescribed by the Board of Directors.
The decision to intervene considers the benefits and costs for the country and its effect on the Central Bank's financial statements. The amounts for foreign exchange purchases are determined in such a way that Banco de la República's level of external liquidity covers the external deficit, the payments of the external debt, and other potential capital outflows.
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