Brazil: The Risks of Monetary Policy

Despite its apparent success so far, the Brazilian Central Bank’s strategy is very risky.

The Brazilian Central Bank (BCB), in a movement that was unanimously forecasted by the market, has reduced interest rates once again to 10.5%. In the minutes of the meeting published last week the BCB, as well as justifying the cut, also announced that others will follow, lowering the short-term rate to a single digit. Although a growing number of central banks has begun to signal the expected future trajectory of short-term interest rates, the fact that the Monetary Policy Committee explicitly declared that the Selic (short-term rate) will fall to a single digit has led to renewed criticism regarding the BCB’s loss of independence in the conduction of monetary policy and an excessive alignment with the wishes that have so often been expressed by important members of the government.

Inflation in 2010 (5.9%) and 2011 (6.5%) was situated well above the target (4.5%). The markets expect inflation to surpass 5% in 2012. But the CB is considerably more optimistic, forecasting in the minutes that “…according to its baseline scenario, inflation will position itself around the target in 2012 and the risks that could prevent inflation from converging to the center of the target are diminishing”.

The BCB’s strategy is based on a scenario of prolonged stagnation in the economies of developed countries, notably in Europe. Thus, low world economic growth would keep international prices under control, maintaining inflation on a downward path as well as reducing GDP growth. On the domestic front, the BCB believes that no inflationary pressures will be generated that could put inflation’s declining path at risk, although emphasizing that to achieve this it is essential to fulfill the fiscal target, moderate credit expansion (and reduce the subsidies) and assure that wage increases are in line with productivity growth.

In sum, the BCB will continue to reduce interest rates in 2012 although inflation is still above the target. A simple belief in inflation’s declining trajectory seems to be enough. What risks does such strategy involve?

The BCB’s baseline scenario is undoubtedly plausible. The problem is the fragility of its underlying hypotheses. If the advanced economies resume growth, if the increase in the minimum wage (14%) and the heated labor market provoke an even greater increase in inflation’s service component, if the 2012 elections lead the federal and local governments to spend more than forecast, if there is a sharp expansion in public bank credit, the BCB’s baseline scenario will be under threat.

Of course the BCB can react and raise interest rates if it perceives that this scenario will not be fulfilled. But there are two problems here. The first is that by reacting after the event rather than preventively with all due caution, the cost (in terms of lost output growth) of bringing inflation back on target will be higher. Secondly, and more importantly, serious doubts currently exist regarding the BCB’s willingness to raise interest rates if the baseline scenario is indeed threatened. In other words, no-one knows what monetary policy’s real objective is.

Most economic agents believe that the center of the target – 4.5% – is no longer an important objective. For the BCB, it is apparently sufficient to prevent inflation from exceeding the band’s upper limit of 6.5%, a view which has indeed been aired for some time by economic authorities outside the BCB.

As this perception becomes more widespread, it is only natural that inflation expectations rise to 6.5%. At the moment market forecasts are not so high. But the real test of the anchoring of inflation expectations will occur if and when some of the assumptions of the BCB’s baseline scenario are not confirmed. With the rise of inflation expectations, many of the benefits of the current system will be lost. Furthermore, bringing inflation back to 4.5% in the future will entail a far higher cost than doing it now.

Another fundamental pillar of the BC’s strategy is the supposition that there has been a reduction in the neutral rate of interest, which is the rate of interest that keeps inflation on target and around which the Selic rate should oscillate, depending on the stage of the business cycle.   As evidence of this reduction, the Monetary Policy Committee (COPOM) meeting’s minutes cite the reduction in risk premiums, following several years of macroeconomic stability. However, the empirical evidence does not corroborate the neutral interest rate reduction hypothesis. If the neutral rate had indeed fallen, the high interest rates of the recent past should have caused low inflation and high unemployment, the opposite of what actually occurred.

The minutes further affirm that “… a factor that has contributed to the reduction of domestic interest rates is the increase in the supply of external savings and the reduction in its cost, which, the Committee assesses as constituting largely permanent developments.” Here there seems to be a certain amount of confusion as to the determinants of the neutral rate. The entry of foreign capital to purchase public – especially long-term – debt, if and when it re-occurs, will undoubtedly reduce the interest rate on these bonds. This, however, will not help the CB to control inflation unless the exchange rate appreciates, which the government, according to the Minister of Finance, will not allow.

Thus, although possible, the scenario underpinning the BCB’s strategy is fragile. There are many risks that may impede its fulfillment especially if, given the confirmation of some of them, the COPOM is not effectively prepared to raise the Selic (short-term) rate. It would be better to return to the tradition of monetary caution which was interrupted on the eve of the 2010 presidential election.