Taylor Rule Signals Colombia Will Raise Benchmark Rate to 3.5%

Few economists accurately predicted Colombia’s central bank interest rate increase last month. The Taylor Rule did and points to a quarter-point increase today, next month and in May, said Citigroup Inc.

Policy makers will raise the overnight rate to 3.5 percent from 3.25 percent if their inflation and growth estimates are applied to Stanford University economist John B. Taylor’s formula, said Citigroup. Twenty-two of 27 economists surveyed by Bloomberg agree, while five expect policy makers to pause.

South America’s fourth-largest economy will grow as much as 6 percent this year after topping 4 percent in 2010, Finance Minister Juan Carlos Echeverry said March 16. Colombia’s credit rating was raised one-step to BBB- by Standard & Poor’s this week, restoring the investment grade status lost in September 1999.

“We still don’t know the effect of the upgrade on the economy or on monetary policy,” said Munir Jalil, chief economist at Citigroup’s Colombia unit in telephone interview from Bogota. “What we do know is that the effect will range from zero to more investment, a faster economy and more inflation which would usually be associated with an interest rate increase.”

Taylor’s formula, which he devised to show the best monetary policy level for spurring growth without stoking inflation, says that a benchmark rate should be 1.5 times the inflation rate, plus 0.5 times the gap between the economy’s potential growth rate and the current pace, plus 1.

Late Start

“The bank’s policy decisions mimic the pure Taylor Rule more often than not,” said Jalil. “The rule shows the normalization process should have started earlier in the year than most expected and that’s what the bank did. Regarding interest rate movements, Taylor still rules.”

Policy makers, led by central bank chief Jose Dario Uribe, last month surprised all but two of 23 economists surveyed by Bloomberg with a quarter-point increase to 3.25 percent. According to Citigroup’s analysis of the Taylor Rule, the bank will raise to 4 percent in May and to 4.5 percent by year-end. Standard & Poor’s decision to raise Colombia to investment grade bolsters those projections, Jalil said.

Over the last month, traders have pushed up yields on Colombian bonds as prices and inflation expectations rose.

Benchmark Bonds

The yield on the Colombian government’s benchmark 11 percent bonds due July 2020 rose five basis points, or 0.05 percentage point, to 8.15 percent yesterday, according to Colombia’s stock exchange. The bond’s price declined 0.334 centavo to 118.101 centavos per peso.

The gap between yields on TES UVR due 2013 and similar-maturity fixed-rate debt, a gauge of annual consumer price increase expectations known as the break-even rate, dropped to 360 basis points yesterday from 430 on Feb. 25.

The spread touched 473 on Jan. 7 amid concern deadly floods in the fourth quarter that swamped crops and destroyed roads, would stoke inflation.

The peso yesterday gained 0.7 percent to 1,880.00 per U.S. dollar.

The 64-year-old Taylor, who served under President George W. Bush as a Treasury undersecretary, published the maxim in a paper for a 1992 conference. Many central banks and economists use a modified version of the Taylor Rule that adds currency fluctuations or capital controls into the equation to assess monetary policy.

‘Worked Well’

“The original version has worked well in practice," said Taylor, in response to e-mailed questions. "But any idea can be improved on as we gain experience. For smaller, open economies, some have found that including an exchange rate can help. But I would advise against including asset prices like equities.”

The central bank uses a series of economic data each month, including inflation expectations, economic growth, retail sales and manufacturing as well as a series of monetary policy models that include the Taylor Rule, said Jalil, a former member of the bank’s technical team.

The bank said it would gradually remove monetary stimulus if the economy continues to grow or inflation expectations deviate from the bank’s target.

Policy makers at last month’s meeting noted their concern about rising Colombian housing prices and the correlation between extended periods of historically low interest rates and “significant acceleration in the growth of credit.”

CPI Expectations

Last month’s unexpected rate increase and a government report showing inflation unexpectedly slowed in February kept inflation expectations within the central bank’s 2 percent to 4 percent target.

Consumer prices rose 0.6 percent in February from the previous month, below the 1.03 percent forecast by economists surveyed by Bloomberg, and 3.17 percent from the same month a year earlier, the third-lowest annual rate in Latin America after Chile and Peru.

Economists lowered their predictions for year-end inflation to 3.48 percent in a central bank survey published last week, from 3.61 percent in the February survey.

“The inflation print last month gives the bank breathing room to hold this month,” said Julian Marquez, an analyst at Bogota-based Interbolsa SA, Colombia’s biggest brokerage, who used a modified version of the Taylor Rule last month to predict the increase. “There is also the Japan effect.”

Japan’s biggest earthquake on record and the subsequent tsunami and nuclear crisis has raised concern economic growth could slow. The world’s third-largest economy imported $511 million worth of goods from Colombia in 2010, more than double imports a decade earlier, when it bought $230 million.

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