Monetary Policy Decision-Making in an Environment of Uncertainty


Monetary policy decision-making requires that two fundamental questions be answered: (1) How is the economy doing? and (2) Where is the economy headed?  The need to assess the status of the economy both in the present and prospectively is due to the fact that the instruments of monetary policy act slowly on the economy. This is known as the transmission mechanism, through which changes in the benchmark interest rate affect other market interest rates with a variable lag that may take up to  six quarters. The answer to each of these two questions involves a significant degree of uncertainty for the following reasons:


1. The information on most of the economic variables (for example, GDP, employment, international trade, etc.) is only available with a lag.

2. Other important variables (such as the output gap or potential growth of the economy, the natural unemployment rate, the real equilibrium exchange rate, etc.) are unobservable, and must therefore be estimated through indirect models and indicators.
 

3. In most cases, it is difficult to predict the origin, effects, persistence, and magnitude of the shocks faced by the economy. Some examples of shocks are: 

  • Changes in external interest rates or in capital flows. 
  • Variations in the international prices of oil, coffee, coal, and other commodities. 
  • Weather conditions that may affect the food supply. 


On the other hand, the scope and effects of the monetary policy are not always predictable because they depend on:


  • Agents' expectations about the future behavior of interest rates, the exchange rate, economic activity, and inflation. 
  • The lags in the transmission of changes to the monetary policy on market interest rates, the demand side of the economy, and other economic variables.
  • The possibility that the same mechanisms of transmission do not always operate, nor that their power is constant. 

 


What actions does the Central Bank of Colombia take to reduce uncertainty?
 

  • It highlights its commitment to achieving price stability as the primary objective of monetary policy in accordance with its Constitutional mandate. 
  • It announces inflation targets in advance so that they can be taken into account by economic agents in their decisions. 
  • It analyzes several economic indicators and uses a wide variety of models with different approaches (statistical and forecasting, structural, and of simulation) to improve its capacity for economic forecast. 
  • It performs sensitivity analyses to assess risks. For example, it analyzes how inflation forecasts change under different scenarios of domestic and international conditions. 
  • It maintains a first-level technical staff, trained on the most recent developments for analysis as well as economic techniques on an international level 
  • It performs research that contributes to understanding how the economy works as well as to develop better methods of analysis.  
  • It interacts with other Central Banks and remains open to the opinion of the national and international academic community by organizing and participating in seminars and discussion forums on topics relevant to the Colombian and global economy. 
  • It organizes regular meetings with various sectors of the Colombian society (entrepreneurs, workers, members of Congress , etc.), in order to learn about their points of view and to explain the decisions and results of the Central Bank's policies. 
  • It implements a policy of transparency through the publication and explanation of monetary policy measures taken by the Central Bank.  

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