Inflation Targeting in Brazil

The National Monetary Council (CMN) has decided today (6/26) to keep the inflation target for 2009 in Brazil at the current level, 4.5% +/- 2.0%. This target is at the upper extreme of inflation targeters, even emerging market ones. As the Table shows, the current inflation forecasts for the next 2 1/2 years are below 4%.

image0025.gifTherefore, the most likely outcome of the recently announced target will be to raise inflation expectations. Given that the Expectations Augmented Phillips curve prescribes that higher inflation expectations will raise actual inflation, ceteris paribus, it follows that for any given actual inflation achieved, the Central Bank will have to set higher interest rates than it otherwise would. In other words, today´s decision will make harder, not easier, for the Central Bank to keep lowering interest rates. This point seems to have been missed in the discussion.

The statements after the decision made the whole story worse. The Finance Minister, who wanted the 4.5%, declared that the decision was taken to provide more flexibility to monetary policy, but that the objective is to keep inflation expectations as they are, below the target. The Central Bank governor, who wanted the 4.0%, said that the decision does not imply that the Central Bank will try to make inflation converge to 4.5%, and that the current inflation expectations should be maintained.

Both remarks highlight that it was a split decision, and that the inflation target regime in Brazil may be losing something that the Central Bank achieved at a very high cost, the very credibility of the inflation target. What is the point to announce a target that will not be pursued?

Economic policy stance has been deteriorating steadily in Brazil since 2006. Today´s decision just strengthens this unfortunate trend. Someday, markets may notice.

5 Responses to "Inflation Targeting in Brazil"

  1. Anonymous   June 26, 2007 at 2:26 pm

    Who sets the inflation target in Brazil? The central bank or the Finance Ministry? If the central bank is truly independent the target should be set by the central bank. But in any democratic regime some political determination of the inflation target should also be part of the process. But in this case the political preferences seem to clash with those of the central bank. How to resolve such a conflict? To provide the central bank with target independence too?

  2. Tom Trebat   June 26, 2007 at 9:06 pm

    The apparent rift between the Central Bank and the Finance Ministry over the decision of the National Monetary Council is indeed puzzling. Granted we are talking about the inflation target for 2009, still the awkward communication today reveals the persistence of structuralist thinking in Brazil long after everyone thought that the so-called neoliberal paradigm had won out. The Finance Minister, probably reflecting political pressures from the PT and its allies to get tough with the Central Bank, argues implicitly that some sort of tradeoff exists between the rate of growth in the long-run and the rate of inflation, i.e., more inflation means more growth because the Central Bank need not be as aggressive in lowering interest rates. This was the dominant mode of thought in Brazil in the 1960s. It is still a cherished tenet, it would appear, of the populist left in Brazil which deeply distrusts the Central Bank. I think all that this reveals is that many points of view about inflation and growth co-exist in Brazil. Today’s decision to set the inflation target at 4.5% (rather than 4% as the Central Bank would have preferred) could also be seen as the democratic process at work, messy as that may be. I do not think it is a significant setback for the policy stance in Brazil.

  3. Christopher Neilson   June 27, 2007 at 11:15 am

    IN my view, the problem has more to do with fact the central bank of Brazil will be targeting something other than the target than the fact it cannot pick its target on its own. Inflation targeting as a framework for monetary policy needs independence in implementation, not necessarily in setting objectives. So the damage being done to credibility is directly associated to the governors remarks and not so much the fact the target was not lowered.  In any case another relevant variable for “flexibility in implementation” (which was not mentioned above) is the policy horizon which is one year in Brasil and the lowest amongst developing economies. This is relevant as DeGregorio (2007) shows, since the time horizon reflects that fact that the objective function of the central bank values both price and output stability. In particular, a direct relationship also exists between the policy horizon and tolerance of inflation deviations from the target, on one hand, and the importance attributed by the authorities to deviations from full-employment output, on the other. The more inflation averse the policymaker, the shorter the policy horizon and the less volatility in inflation will be tolerated.  In that sense, an alternative which might have been a win win situation would have been for Finance Ministry to have pushed for a longer horizon (say two years as in Chile) and let the CB lower the target in line with current expectations.

  4. Italo Lombardi   July 3, 2007 at 9:43 am

    Transparency is key on an Inflation-targeting regime. The disagreement between the finance ministry and the BCB not only increased the uncertainty on the real target but it was also responsible for derailing the BCB from setting a lower target (4.0% or less) crucial for the consolidation of the credibility and the inflation-target regime. Indeed, very disappointing …

  5. jseabold   December 6, 2007 at 6:11 pm

    Does the Central Bank of Brazil target inflation as measured by the CPI? I thought they used the IPCA.