Brazil is being considered the new Bundesbank. In other words, many economists are saying all over the world that perhaps Brazil is the country which is following more strictly the inflation targeting rules and models, respecting the existence of only one true instrument of monetary policy – the nominal interest rate – and treating scientifically the concept of potential output and output gap.
Consequently, in spite of the turmoil with commodity prices and the US financial crisis, it seems that Brazil is being able to contain inflation within reasonable limits, by following the rules of inflation target models coupled with floating exchange rates. As a matter of fact, without any doubt, such models consider that the nominal interest rate affects inflation through many channels, including the level of economic activity and the level of the exchange rate.
In the case of Brazil, for example, nobody doubts that a 100% nominal appreciation of the real against the dollar since 2003 was a major factor to keep inflation low, in spite of the US$ increase in commodity prices. And this appreciation was mainly due to the high level of nominal interest rates against other currencies such as the dollar, the euro, the Swiss franc and the yen.
On the other hand, there is a certain degree of preoccupation nowadays because credit is expanding very rapidly in Brazil, in spite of high and increasing nominal interest rates, and this is certainly keeping a high level of economic activity and employment, which is not necessarily what the inflation target models were predicting.
In other words, it is the impact of interest rates on the exchange rate which is helping to keep inflation low, even though credit is booming and the economy itself is booming (although the definition of a “Brazilian boom” in this century is different than 30 years ago, when the country used to grow at 10% per year – and not 5%.)
But we would like, in this article, to raise some doubts about the role and the power of monetary policy – strictly defined as a nominal interest rate policy – over inflation. Brazilian historical experience suggests that, in a country with hyperinflation memories, two-digit nominal interest rates might begin to lose their impact on inflation, to the extent that the economic agents – Central Bank watchers and/or non-watchers – begin to change their interpretation about two-digit nominal interest rate movements in the upward direction.
It is well known the Fisher equation, where nominal interest rates are different from real interest rates by the concept of “inflationary expectations”. The problem of monetary policy in countries like Brazil is that, at one point, they control of course nominal interest rates but do not control inflation expectations (or, for that matter, also do not control devaluation expectations). In consequence, at a certain (or uncertain) point in time, raising two-digit nominal rates might represent even a decline of real interest rates, when and if the expectations about inflation and devaluation begin to behave like bubbles. Yes, there are also expectation bubbles – and economists know little about that.
It is possible – but I would emphasize: just possible – that the next increase of nominal interest rates in Brazil will not impact neither the exchange rate nor economic activity. Because real interest rates will go down significantly. People will begin to fear devaluation and higher inflation. This is the dilemma that existed before the Plano Real of 1994, before the Inflation Target Model of 1999, and that might very well come back, bringing the ghosts of the seventies and eighties.
After all, why did inflation go up from two-digits in 1963/1979 to three- digits in 1980/92 and then four-digits in 1993? Were the Monetary Authorities so incompetent during those 30 years? No. What happened is exactly that nominal interest rates lost their power as a monetary policy tool and, worse, began to affect dramatically the fiscal deficit. A race started between nominal interest rates and inflation expectations. A race that was lost by economic policy.
And then came the brilliant Plano Real in 1994, followed by the Arminio Fraga Inflation Target Model of 1999 and – surprise! – inflation practically stopped. The race was stopped by a brilliant combination of economic policy measures in both cases.
However, without being too pessimistic, we fear that the ghost of inflation expectations is back and somewhat out of control. And this will only be fed now with even higher nominal interest rates. A new race is beginning: a dangerous one.