Monetary Policy Decision-Making in an Environment of Uncertainty

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The Bank decides over the monetary policy interest rate considering the analysis of the current situation of the economy, its outlook, and the evolution of the inflation forecast vis-à-vis the inflation target. If, as a result of this assessment, the Board concludes that there are risks of inflation deviating persistently above the target in the horizon in which this policy operates, the monetary authority will increase the policy rate. Likewise, if the economy exceeds a rate of sustainable growth, there could be spending sprees that compromise price stability or lead to financial fragility. In this context, the Central Bank will raise the benchmark interest rate in order to prevent strong future falls in production and employment. 

In order to make monetary policy decisions, the Board of Directors assesses the present and future situation of the economy, as well as the inflation forecast and its deviations from the inflation target. This is due to the fact that appropriate monetary policy actions depend on the nature of such deviations. If the variations in consumer prices originate in demand (spending) pressures, the risk of output exceeding its sustainable level coincides with the risk of inflation standing above target, and vice versa. This happens because a very strong aggregate demand presses the use of installed capacity of the economy and generates greater increases in production costs. In these circumstances, monetary policy actions aimed at stabilizing expenditure and production around their sustainable values also stabilize inflation around its target. In this case, achieving the inflation target is compatible with the objective of reaching the maximum sustainable level of output and employment.

However, it can happen that, in the absence of an excessive demand, there may be upward pressures on inflation caused by temporary restrictions on the supply side of the economy. In these cases, the rise in the cost of production increases and firms reduce their production and employment. In such a scenario, there is a risk that deviations of inflation from the target extend beyond the duration of supply shocks. However, if the inflation target is credible, i.e., the markets expect that the Central Bank will not allow a persistent gap between inflation and the 3.0% target, expectations will remain aligned with the target. In these circumstances, the monetary authority can ensure future compliance with the inflation target without incurring in large fluctuations of production and employment.