In order to reanchor expectations, the elected president will have to prioritize inflation’s return to its target.
In its latest poll among economic analysts, the Brazilian Central Bank (BCB) computed the median of inflation expectations for 2014 above 6.5%, the ceiling of the band around the inflation target (4.5%). This has heated the debate about macroeconomic policy and inflation control. Despite the recent rise of the basic interest rate (SELIC), from 7.25% to the current 11% level, inflation and inflation expectations continue to move upwards. The oncoming stop on SELIC’s rise, already clearly indicated by the BCB, will have to be temporary, under the risk of breaching the target.
The chart synthesizes, since 2001, the performance of the inflation targeting (IT) regime regarding inflation expectations. The target underwent, initially, several changes. Since 2006, it has been settled at 4.5%, with a “tolerance interval” from 2.5% to 6.5%. The target is compared with 12-month-ahead inflation expectations, a period deemed long enough for the BCB to bring the inflation back to its target. The difference between inflation expectations and the target is the area entitled “Expected Deviation from Target.” The chart also contains the SELIC rate. The latter two series’ units are on the right-hand-side scale.
From 2006 to 2010, the deviations from target alternated between positive and negative values, indicating that the market believed, back then, that the BCB was in fact trying to achieve the 4.5% target. In recent years, however, this has no longer been true. The deviations have become systematically positive and increasing. The chart also illustrates the SELIC’s effect on inflation expectations. Until 2010, SELIC’s elevations always produced significant drops in inflation expectations (and in inflation as well, though not shown in the chart). This also stops occurring, especially after the sudden and clumsy SELIC reduction, by the end of August 2011. To sum up, monetary policy has suffered from a visible credibility loss over the last few years, as it has been confirmed by several studies.
Unanchored inflation expectations make the BCB’s job much harder. Forecasting inflation above the target, firms revise prices more often, while workers ask for higher wages, in the well-known wage-price spiral. In order to put this process in check, the BCB must raise the interest rate even further.
There are, however, examples in which central banks managed to reverse unanchored expectations without being forced to incur the costs of very high interest rates. In May 1997, after the Labour Party’s electoral victory, the recently nominated UK prime minister, Tony Blair, granted instrument independence to the Bank of England to pursue the inflation target of 2.5%. Immediately, inflation expectations, as well as long-term interest rates, fell abruptly, in a clear credibility gain for the new monetary policy regime.
It is unlikely that something similar might occur in Brazil until the next October general election. Regardless of who wins, the next president should announce that promoting the return of inflation to the target will, again, be a priority for the BCB. Such a task becomes even harder due to the repressed inflation (electricity, gas, public fares etc.) which is likely to be postponed to 2015, and is estimated between 120 and 150 basis points. Granting operational autonomy to the BCB, as did the Labour Party in the UK in 1997, would be a key measure to reinforce the anti-inflationary credentials of the new government. The new priorities should be extended to the other macroeconomic policies, reversing the fiscal and parafiscal expansion seen over the last years. On the other hand, the persistence of the current BCB’s credibility loss process beyond 2014 may take inflation, and the Brazilian economy, onto a very risky path. God forbid this should happen!