Opinion – Solange Srour: Losing the monetary anchor?

Economic theory assigns an important role to inflation expectations as one of its determinants. If inflation projections rise, consumers anticipate their purchases, workers demand higher wages, companies readjust their prices, savers seek real assets, and prices rise. Expectations are like an anchor—when they consistently diverge from the target, inflation drifts.

We are going through one of the most challenging moments since the beginning of the target regime, in 1999. After missing the center of the target by a difference of more than six percentage points in 2021, the risk is that a similar difference will occur this year and that the IPCA exceeds the target ceiling in 2023.

With the BC employees’ strike, we don’t know how inflation expectations from the Focus survey are behaving. However, the implicit inflations of public bonds indexed to the price level point to 6.6%, 6.4% and 6.2% in the next 12, 24 and 36 months, respectively – well above the 3. 25% in 2023 and 3.0% in 2024.

However, the most uncomfortable aspect is that long-term expectations are also being affected, despite the ongoing strong monetary tightening. The expected rate of inflation over the next 5 to 10 years is currently at 6.7%, more than double the long-term inflation target of 3.0%.

Since 1999, Brazil has gone through seven cycles of monetary tightening: 2001, 2002-03, 2004-05, 2008-09, 2010-11, 2013-15 and 2021-22. In all cycles, the BC raised interest rates when forecasts started to move away from the target and only stopped the movement when forecasts stabilized or started to converge towards the target. This is the first time that the Central Bank has signaled its willingness to end the monetary tightening with expectations still in the process of divergence, which jeopardizes the credibility of the inflation targeting system. The fact is that, today, agents do not believe that restrictive interest rates and the expected deceleration of activity will produce a disinflation compatible with the target.

It is in this context that proposals arise on how to avoid further short-term pressures on the price level, such as the freezing of fuel prices and the suspension of the readjustment of electricity tariffs. The country’s experience in 2011-16 shows that direct government interference via administered price controls — as well as the destruction of the fiscal framework — becomes a liability for inflation in the not too long term.

The approval of the complementary bill nº 18/2022 in the Chamber (establishing a ceiling for the ICMS rate levied on fuels, telecommunications, electricity and public transport) has the potential to reduce this year’s IPCA by about 1.3 percentage points . Although it is not a freeze, the proposal only helps to contain inflation expectations this year, without changing the longer term expectations in any way.

It is not initiatives like this that will bring comfort to the BC. If it chooses to end the cycle of high interest rates in June or August, the monetary authority will communicate a period of more gradual convergence of inflation to the target, including the year 2024 as the relevant horizon of its action. Probably, to minimize the damage to its credibility, it will commit to keeping the Selic rate in contractionary territory for a long time.

Although it is not credible to aim for the 2023 goal, given the inertia that will be carried over to next year, the 2024 goal is perfectly feasible. Everything will depend on the credibility of the BC’s communication, its actions and the maintenance of fiscal responsibility after 2023.

​There is little need to be careful, as the further expectations move away from the target, the greater the coefficient of inertia, making the disinflation process even more costly —in terms of GDP— in the medium term. The challenge of taming inflation is far from trivial.