Brazil: Monetary Policy Dilemmas

When and if it occurs, the desirable recovery of the global economy will challenge the current combination of controlled exchange rate and low interest rates.

With the 0.5% reduction of the base rate (Selic) last Wednesday, August 29, the current cycle of monetary easing reached the same amount that had been accumulated in the aftermath of the 2008 crisis, 5%. Since it started off from a lower level, 12.5%, the Selic is currently at the historic low of 7.5%. Copom’s press release after the meeting made it clear that if there is any additional reduction, it will be at 0.25%.

On the same day that the Copom’s decision was announced, the finance minister announced a new fiscal package (the eighth), with renewed fiscal exemptions and greater credit subsidies. Aside from temporarily raising industrial products sales, the exemptions also have the effect of avoiding the rise of the current inflation, at the cost of the future one. The new fiscal package not only reveals a more pessimistic scenario than the one predicted by the Central Bank as to the economy’s recovery, but also demonstrates that the fiscal policy will remain expansionary.

How will the economy react to the low Selic rate? Will the cut be enough to reactivate economic activity? How will the exchange rate react? Can inflation rise?

Como reagirá a economia à baixa taxa Selic? Será a queda suficiente para reativar a atividade econômica? Como reagirá o câmbio? A inflação pode subir?

The answer to all of these questions will depend, more than usually, on international events: on the evolution of the Euro crisis, on the magnitude of the slowdown in Chinese growth, and on the strength of the economic recovery in the US, also threatened by the political paralysis generated by the exacerbated antagonism between Republicans and Democrats.

Unfavorable scenarios may be quite varied: from the persistence of the current lethargy in the developed countries to a deep contraction of international credit in the wake of the Euro dissolution, the collapse of important banks and the default of sovereign debt. The government has numerous possible responses to the eventual resurgence of the international crisis, as demonstrated in its reaction to the 2008 crisis. Nevertheless, it would be an illusion to believe that Brazil could grow while the world faces a recession.

A more favorable scenario would lead to a rise in commodities prices. In the past, the floating exchange rate balanced the rise in commodities prices with the appreciation of the BRL, following the increase in export levels and foreign investment inflows. However, the current exchange rate regime no longer allows for this possibility. The graph shows how the exchange rate, after crossing the 2.00 BRL/USD level in mid-May, has been kept in a very narrow band through interventions of the Central Bank. This exchange rate policy (an exchange rate band?), in a scenario of higher international prices of commodities, could result in a rise of the inflation rate, and the current Selic rate would no longer keep inflation at bay. The market’s forecast for the hike of the Selic rate in 2013 is only a reflection of such fears. So, should the best scenario come true, taming inflation will require a choice between keeping the exchange rate under control or keeping the interest rate at the current historic low.

One could argue that, in this friendly international scenario, the inflationary pressures could be mitigated through a new round of macroprudential measures that constrain credit expansion. Even though the effect of the macroprudential measures from late 2010 has been positive, its power to regulate the business cycle cannot be overstated. Through its official releases, the Central Bank always correctly underscore that macroprudential measures are not substitutes for monetary policy measures and thus, should focus primarily on preventing risks to financial stability.

In conclusion, Brazil can grow at higher rates, in case the best international scenario happens. But, in said scenario, one of the two: either Brazil will have a lower exchange rate combined to higher interest rates, or it will face higher inflation.