Greenspan in the mirror: risk management in Brazil’s monetary policy

A lot has been said in recent years about why Brazil has high interest rates and we shall return to the issue. Let me today address one aspect of the latest monetary policy cycle in Brazil, namely the risk-management approach embedded in the decision by Brazil’s Central Bank (BCB) to hike basic interest rates by 375 bp between September 2004 and May 2005, followed by a gradual easing that has been in course since September 2005 (725 bp so far and counting…). I believe the episode illustrates how there still is a blind spot not frequently addressed in discussions about assignment of responsibilities between non-monetary authorities and operationally independent central banks in the context of inflation targeting regimes in Brazil and elsewhere.

            At the time those decisions to raise interest rates in Brazil were made, some critics characterized them as an over-reaction to what they called feeble signs of return to higher inflation. As effective inflation moved to the range bellow mid-target in 2006, the same critics suggested this would be a demonstration of the over-kill monetary stance adopted by the BCB.

            A shortcoming of over-simplified versions of this critique is their exclusive reference to observed data, thus keeping out of sight those scenarios that were precluded by the same monetary policy decisions. In fact, one should take into account all possible alternative scenarios with significant probabilities and consequences, even when doing an ex post assessment.

            In order to clarify my argument, let me resort to Alan Greenspan’s oft-quoted speech in Jackson Hole in 2005 – Reflections on central banking – where he formulated his view on the risk-management approach to monetary policy that the Fed applied while deciding what to do with interest rates in the summer of 2003. As we all know, the deep reduction of Fomc’s nominal rate to 1% and the “measured pace” with which it was lifted afterwards have been criticized by some as over-lax and as a major factor behind excessive global liquidity and widespread asset bubbles thence forward. In his speech, Greenspan emphasized how policy decisions had – and always have – to be taken in a framework of expected risk-weighted benefits and costs, one in which the total loss-function is to be at the core:

            “(…) a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decision makers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy. (…) point forecasts need to be supplemented by a clear understanding of the nature and magnitude of the risks that surround them. In effect, we strive to construct a spectrum of forecasts from which, at least conceptually, specific policy action is determined through the tradeoffs implied by a loss-function.”             He then goes on to explain why the option of sticking to an apparently over-soft policy was taken:

            “In the summer of 2003, for example, the Federal Open Market Committee viewed as very small the probability that the then-gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates. The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. (…) Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs.”        

            In my view, the context of monetary policy decisions in Brazil in mid-2004 resembled an inverted image in the mirror of the one depicted by Greenspan for the US in the summer of 2003. In terms of a loss-function – in which the product of probability times loss given the event is what matters – the damage of a failure in curbing inflationary threats at that moment in Brazil was considerable.

            The inflation targeting regime implemented since 1999 was still in the middle of its trajectory of downward annual targets toward long-run levels closer to the rest of the world when it was hit by the tremendous confidence shock of 2002. Inflation targets were missed in 2002-03 and adjusted targets had to be established.

            Market expectations about inflation started to exhibit strong downward rigidity in 2004, what seemed to express a lack of confidence on the capacity of monetary authorities to withstand enormous political pressure toward softening. After all, the lack of legal operational autonomy and the painful GDP-effect of monetary policy in the beginning of President Lula’s mandate were read by many as enough to undermine the BCB’s capacity to react to the imported shock of increases in commodity prices abroad that was behind creeping inflation hikes at the time.

            In that context, independently of the likelihood to be associated to a scenario of inflation levels moving upward from the then prevailing ones (still above 7% p.a.), one can argue that future sacrifice ratios would have risen substantially in the case of a failure to halt the contamination between expectations and creeping inflation. Thus, “loss given failure to counter inflation” – or “loss given not mastering expectations and weakening reputation” – might be seen as justifying the 375 bp hike in basic interest rates, even if that augmentation was liable to be deemed as exaggerated. To those who argue that the speed of convergence of inflation toward levels below 4.5% (the mid-point of the target range) is a proof of excess monetary conservatism, Brazilian central bankers can point out the risk-management approach and that “given the potentially severe consequences of [inflation], the expected benefits of the unusual policy action were judged to outweigh its expected costs”, adapting Greenspan’s remarks.

            To finalize, let me refer to a blind spot in usual discussions on the task division between democratically elected non-monetary authorities and an operationally autonomous central bank in inflation-targeting regimes. The former take the responsibility of assessing trade-offs and defining inflation targets, whereas the latter receives full autonomy to fulfill its contractual commitment, namely to deliver target inflation. Central bank’s accountability insofar as its decisions over time is possible by examining these decisions at the light of means-ends relationships. Nonetheless, when it comes to the subjective component of assessments inevitably present in risk-management decisions, the borderline demarcating responsibilities is somewhat blurred, in formal terms at least.

7 Responses to "Greenspan in the mirror: risk management in Brazil’s monetary policy"

  1. Nouriel   May 28, 2007 at 5:10 pm

    Otaviano, your analysis of how the risk management approach of Greenspan could be applied to explain the BCB tighteing in 2004-05 makes a lot of sense and is quite valid.   But what about the present and the future policy dilemmas rather than those of 2004-2005? You partly finessed for now the question of whether – now that the inflation targets have been over-achieved – the BCB should or should not ease at a faster rate. And what about the implications of the pace of monetary easing for the continuation of the capital inflow episode currently experienced by Brazil?   To manage these excessive inflows should Brazil allow further nominal/real appreciation? Should it ease monetary policy faster? Should it continue with sterilized intervention? Should it tighten further fiscal policy? Should it liberalize imports at a faster pace? Should it impose capital controls on short term capital inflows? What are the answers that a risk management approach gives to this monetary/currency and other policy decisions?  Nouriel

  2. Otaviano Canuto   May 28, 2007 at 9:12 pm

    Brazilian central bankers are currently facing great uncertainty with respect to what is still to come in the pipeline in terms of demand acceleration as a result of the long sequence of past and additional interest rate cuts in the near future. The economy seems to be undergoing a period of structural break, even without any new major structural reform being implemented – as manifested by asset prices apparently anticipating an investment grade soon – maybe because only now the fruits of macro stability are really unfolding. The recent review upwards of GDP figures accentuated the lack of confidence on using filters HP or other backward-looking references as a benchmark for estimating potential GDP growth rates. Everyone knows that the basic interest rate is closer to its “normal” rate than in any moment of the last few years – finally after such a long period of exceptionality! – but not how much! The economy is growing strongly but no one can be sure about whether the rates of used capacity are not about to climb in the following months (monetary lags are changing due to intensive change in credit and capital market activities). The scenario of maximum loss in case the BCB decides to keep the current rhythm of 25 bp cuts per meeting and this shows up to be too conservative is some output loss and a delay in finding the prevailing “normal” rate, whereas the max loss if a change to 50 bp per meeting reveals itself as over-shooting would be a policy reversal in 2008. They will have to move meeting-by-meeting, leaving always open the possibility of altering the rhythm. For the next meeting, my personal bet is for 50 bp! On the exchange rate: if the interest rate were to be held responsible for avoiding BRL appreciation it would have to fall substantially in the near future and that would conflict with its attribution in the inflation-targeting regime, as described above. As the interest rate approaches its “normal” level, one cannot count much on it as a means to dissuade capital inflows. BTW: so far, given the trade and current-account performance above expectations, as well as the fact that there is no sign of bubble-type domestic credit binge or stock overvaluation, there is some ground to believe that Brazil is not undergoing a boom-bust cycle as the one of the 1990s. If you, Nouriel, score on your present forecast for the world economy, then prices of commodities will fall and Brazil’s BoP will stop shining, but then domestic interest rates will be allowed to fall further… I don’t think the risks associated with the current BRL appreciation deserve ad hoc measures (such as capital controls, sterilization without limits etc.). Of course, this is not to deny the benefits of any well-crafted fiscal reform and trade opening, but on their own and not because of capital inflows and exchange rates.

  3. M.C.   May 29, 2007 at 5:35 am

    Great comment about the risk management of the monetary policy outcomes! I remember another excellent paper Blinder & Reis (Understanding the Greenspan Standard; 2005) that is one of the best papers in this subject.  In 2004, the cost of the credibility loss was really high relatively the benefit of more inflation accommodation considering that the GDP was growing very fast. In other words, the inflation deviation from the target was relevant (some market players were betting that inflation would be above the IT upper limit in that year) but the GDP was growing above the potential at that moment (something around the double of the average). I would also point that the opportunistic disinflation approach could be a good fit to the happenings (gradual movements and patience to wait the inflation convergence).  But, what about the actual cycle? Should we increase the cut magnitude because the inflation is under the central target? Are there benefits to take more risk and eventually anticipate the end of the monetary easing? We know the economy is showing many signs of increasing internal demand and we need to consider the lag effect – of the last and next movements.  What is the outcome we really want to avoid – the maximum loss scenario? I think it’s the one in which we have much more growth in the next trimesters that would cause an interest rate hike in the end of 2008.  The bigger cut scenario would be the bad outcome just if we had a significant international turmoil. Would Brazil lose the opportunity of rate convergence to the international standard? I don’t think so. In this scenario the marginal effect in inflation is good to continue cutting interest rate. The commodity price fall would be dominant comparatively to the expected exchange rate depreciation since the Central Bank has insurance as big as U$ 130 bi of international reserves.  Which scenario do we really want to avoid?

  4. Paulo Hermanny   May 29, 2007 at 9:21 am

    Otaviano,  You have provided an excellent analysis of current economic policy trends in Brazil. I have to agree on every topic, but I also share my scenario to Brazilian Economy and help answering some Nouriel’s questions:  1) The BCB is likely to accelerate the easing pace to 50 bps, not only in the next meeting but until the yearend, i.e. Selic closing the year at 10%.  So, will inflation remain low enough to induce faster convergence? Probably so. In fact, on the activity side, recent productivity gains have been easing pressures on the output gap. On the external front, intense trade flows and high interest rates have produced the strongest real BRL since the introduction of the floating regime. On one hand, a strong currency tames tradable prices, which helps to ease inflation. On the other hand, it boosts imports expanding the aggregate supply.   2) Capital inflows shall remain steady and the BRL should appreciate towards 1.75 by 2008.  External accounts should remain robust, close to last year’s levels. Despite the strong currency, exports should remain buoyant on the back of increasing commodity prices (yes I still bullish), higher productivity and steady international demand. In fact, the first two drivers induce a stronger equilibrium BRL. Higher commodity prices improve terms of trade and higher productivity triggers the Balassa-Samuelson effect. In addition, the interest rate differential remains substantial and should remain so over the next year. Moreover, the scenario indicates a decrease in parallel with the risk premium leading to a stable risk-adjusted return.   3) The BCB should reduce the reserves buildup process. The CB has increased the pace of reserve accumulation in the past months. International reserves now stand above USD 120 bn. In April alone, the Bank bought over USD 12 bn, a historical record. Since mid-2006, the CB has conducted the longest and most consistent reserve buildup ever. Actually, the volatility of reserve accumulation is currently as high as in the 1999 speculative attack. It shows that the CB is inducing a dirty float in its efforts to weaken the currency. However, the marginal cost is increasing and might become higher than the benefit anytime soon. Clearly, this path is not sustainable and the CB can be expected to slow the acquisition pace soon.   4) Investment Grade should become a reality in 2008.  Over the last weeks, Fitch and S&P have upgraded Brazil to BB+, one notch below IG. Moody’s should follow the same trend. This upswing did not occur by chance but was due to a sharp improvement in fundamentals, indeed the best set ever. Brazil is now a net creditor abroad. Its net debt is decreasing and set along a sustainable path. It also has a history of sound economic policies.   In addition, I list some points that I would like to see but is unlikely to happen over the next years:  5) Reduction in tax/quotas of imports.  6) Liberalization of the capital account.  7) Drastic cut in government spending followed by tax reform in order to reduce the tax burden.

  5. M.C.   May 29, 2007 at 1:44 pm

    Mr Hermanny  I understood that in your bullish base scenario the BRL appreciation could do the entire job to maintain the low inflation in Brazil (from 1.95 to 1.75 BRL/USD). So, the tame tradable inflation could dominate upper pressure from non-tradable sector in an environment of high growth rates.  The evidences suggest that the pass-through coefficient is falling in recent data. I interpret this result as consequence of strong internal demand that reduces the pressure from the international competition. Although, we are witnessing a huge import growth, we know that imports can’t supply all the “marginal absolute” increase in domestic absorption. So, the industrial utilization is clearly getting closer to the historical highs, as expected. It is worth to mention that the extremely favorable aggregate capital expenditure mitigate the possible inflation pressure – suggesting continuity of monetary easing.  In this sense, I still believe that the scenario we want to avoid is the high growth / high inflation which would call for a reversion of monetary easing. If I were in the central bank position, I would not bet on the future path of BRL/USD and would keep cutting the primary interest rate in the slow mode, checking the economy and lag effects.

  6. Paulo Hermanny   May 30, 2007 at 8:15 am

    M.C.  I agree with your arguments but not with your conclusion. In fact, whether the monetary easing will be faster or not strongly depends on the path of the BRL. The joker is in BCB hands as it can slow down the buildup process and induce further BRL appreciation. Indeed, we need to assume that the international scenario will remain benign. In fact, I see now a golden window to normalize interest rates.  We also have to consider the other side of the risk distribution. The BCB could miss the chance to achieve a high growth/low inflation/international rates equilibrium, which is in my view BCB’s final objective. Brazil is the only EM with abnormal real interest rates, almost 10%, but at the same time belongs to the selected group with inflation lower than 4%. But, the convergence process works this way. First inflation comes down and is expected to remain low – now at 3% in Brazil. Only then would nominal rates be able to fall low enough to bring real rates down. This is the dynamics of the convergence of interest rates as supported by international evidence.

  7. Renato Caporali   June 4, 2007 at 11:36 am

    Otaviano, muito interessante análise, sobretudo porque ela explica a racionalidade de uma decisão que, expost, poderia parecer totalmente equivocada. Mas também me parece também pertinente sugerir um certo excesso de prudência no periódo subsequente à elevação da Selic, onde a esse excesso podia ser mensurado pela velocidade da valorização do real. Se o real se valorizava demasiadamente rápido e a taxa de inflação convergia para baixo do centro da meta, eram dois sinais firmes de que a taxa de juros estava acima do que poderia – e nesse caso, deveria – estar.   Eram portanto uma evidência de que o cenário de risco estava se tornando benigno demais, e que a política monetária poderia ser mais audaciosa, o que nesse caso equivale a menos conservadora.   Do alto da minha singeleza em macroeconomia, me parece que é possível estabelecer um tradeoff entre taxa de juros e valor da moeda: se a segunda se valoriza demasiadamente rápido e em proporções muito elevadas, temos um sinal firme de que a taxa de juros está acima do patamar mais adequado. Se, ademais, a meta inflacionária desceu abaixo da média, o sinal se torna eloquente. Não vejo porque quedas não possam, em condições tais, ser superiores aos 50 pontos.  Renato Caporali