“Having assessed the macroeconomic outlook and the prospective inflation scenario, the Copom unanimously decided to raise the Selic interest rate to 11.75 percent p.a., without bias. The Committee understands that the decision to immediately materialize a relevant part of the basic interest rate move will contribute to a prompt retraction in inflation risk and, as a consequence, to reduce the magnitude of the total adjustment to be implemented”. (Central Bank of Brazil, April 17, 2008).
That’s it! According to the central bank authorities inflation is back in Brazil. Moreover, inflation risk is once again a huge concern to them. The country, with its inflation history, renews its struggle against inflation pressures. Under an inflation targeting regime central bankers have no instruments other than the interest rate, which was therefore raised higher than the inflation pressure. As expected according to the theoretical approach to monetary policy, in a couple of quarters inflation rates will go down through the conventional mechanism of aggregate demand. Yet, domestic central banks in emerging market economies are expected to individually cope with raises in prices.I don’t feel as confident as the Central Bank of Brazil. Why not? I am not sure about the decision basically because where a large part of the inflation pressure originates and also because of the worldwide economic downturn.
Let’s begin with the facts. Inflations rates are higher across the world this year relative to either last year or even the last decade. Consumer prices in America rose by 0.3% in March, a total 4% price increase from one year earlier. But with the exclusion of energy and food, prices rose by 0.2% in March. Consumer prices in Britain and the Euro area rose by 2.5% and 3.6% in the year to March, respectively.
According to economic and financial indicators published by The Economist (April 17th 2008), forecast consumer prices are generally higher in 2008 than one year ago in most economies, such as Russia (12.5% against 7.4%), China (5% against 3.3%), Japan (-0.2% against 0.7%), etc.
Most likely, the one very important reason for the increase in consumer prices can be closely associated with the extraordinary rises in commodity prices. According to The Economist Commodity-Price Index, food is the major source of the recent pressures. While the full index increased by 31%, food rose up to 65%.
In a somewhat non-linear contagion, commodities prices (including oil) started to contaminate consumer prices. It hadn’t been like that so far. At the same time, and in addition, the marginal cost of labor has risen, particularly in China. Then global inflation became a major concern. Brazil is rather the rule than an exception. With the over-valued Brazilian Real and imports increasing by 54% a year,1 world inflation is also imported, especially at this time of high-performance aggregate domestic demand. Additional contributions come from the substitution process, from production to domestic market to exports in times of high international prices. Finally, domestic prices of food rose as well.
Let’s get back to the Brazilian authority’s recent decision to hike interest rates. Just as a matter of curiosity, Brazil again has the highest benchmark real interest rates worldwide. It is the only economy that has chosen to raise interest rates at this time of worldwide economic slowdown. It is also an economy that has had a persistently high level of short-term real interest rates in the last two decades. What is going on?
The Central Bank of Brazil is certainly following its theoretical model. And this is, in a way, just half of the making-decision process. It is called science. However, as it is also an art and, therefore, it might have been better to accommodate and wait and see. This should be the time to get help from the fiscal policy and batten down the hatches for a protracted U.S. slowdown. A higher short-term real interest rate right now seems quite dangerous for the medium-term scenario.
The same thing has happened in the past, when the Central Bank of Brazil unnecessarily kept the interest rate higher than prescribed by a reasonable empirical model as can be seen in the IMF Working Paper 07-291. According to these estimates, a central banker should be prudent rather than conservative and, for various periods of time, short-term real interest rates were higher than predicted by the model
To make this point clear, the following medium-term outlook appears evident: first, more stress is expected toward an over-appreciated Brazilian Real, with bad consequences for the trade balance; second, a greater fiscal effort will be required in terms of the primary surplus to compensate for the higher financial burden of the domestic federal debt and the consequent increase in debt; third, if the U.S. slowdown lasts for more than two quarters, as most international analysts expect (see blog Roubini), and other central bankers keep lowering their benchmark interest rates, this will add to the severity of the two consequences above; and fourth, due to all the foregoing reasons, the Brazilian economy will soon grow much less than its peers, as has been the case in the past two decades.
As scientists, Brazilian authorities should expand their theoretical model to better take account of the role played by recent global economic activity. And, as artists, they should have waited and seen.
(1) Imports increased 54% in January-February 2008 in comparison to same period in 2007.