Ana Paula Vescovi: There is no painless fight against inflation

Price stability is essential to sustain maximum employment and economic activity. However, there is no fight against inflation without a significant rise in interest rates and, therefore, without undesirable side effects: contraction in activity and temporary increase in unemployment.

This was the conduct adopted by the Federal Reserve (the central bank of the United States) under the command of Paul Volcker (1979 to 1987), and we still know today that the best social choice over time is the permanent control of inflation. Combating outbreaks brings social costs, albeit temporary. Not doing so implies accepting stagflation, with the aggravating factor of accentuating income inequality, losing social cohesion and, ultimately, feeding authoritarian political regimes.

There is no middle ground in fighting inflation; it is essential to leave no doubt about the commitment of the monetary authority. In the 1980s, after two oil price shocks and a succession of unconvincing monetary tightenings, Volcker imposed an interest rate shock on the US for as long as it took to break the inflationary inertia.

Obviously, the cost was enormous — the recession between 1981 and 1982, in addition to the crash in countries with high dollar debt, a typical case in Latin America. However, it made room for two decades of sustained global growth.

The current inflationary surge has caused concomitant shocks, stemming from the pandemic and, now, the war between Russia and Ukraine. Average international commodity prices have risen 50% in dollars since 2020; more than 80% in reais. In addition to the unprecedented injection of stimuli, which caused demand deviations, there have been interruptions of production and logistics chains due to lockdowns and geopolitical issues. The combination of this mismatch between supply and demand with excess global liquidity and increased risk in asset markets makes the work of monetary authorities more complex.

Central banks have been playing their part, although clearly late in the process. After the initial phase of belief that inflation would be temporary, it became evident that the rise in prices had spread to wages and services.

Combat instruments are not lacking, but these are crude. As the disorganization of global chains takes time to correct, the remedy is to contain demand by raising interest rates. If the authorities show that they fear the social costs of a strongly contractionary monetary policy, instead of being avoided, these costs will only be prolonged and imply even more social sacrifices.

In the last 12 months, consumer inflation has accumulated a high of 8.3% in the United States; 8.1% in Europe; 9.7% in Latin America and 12.1% in Brazil. For many, it is the first experience of living with inflation close to double digits. And for those who have experienced it, the current level of inflation brings to mind two decades of low, erratic growth, few opportunities and rising inequality.

Only after that did the world reap a period of sustained growth.

The abundant liquidity injected since 2020 (14% of global GDP) has helped to build artificial monetary wealth, which tends to be destroyed with monetary normalization. This is already starting to happen in riskier markets, such as tech stocks and cryptocurrencies. For governments, at first, inflation automatically helps to increase public revenues and, unlike disinflation, overshadows the harsh reality of structural fiscal imbalances.

Thus, the risks of the global disinflation process are immense and concern the stability of financial markets. Central banks have managed to converge on the thesis of the need to combat the deterioration of inflationary expectations. Empirical evidence indicates that interest rates and activity are more sensitive to expectations than to current inflation. It is through the channel of expectations that producers and workers seek to restore prices and wages.

In Brazil, the BC started raising interest rates earlier, because inflation started to get worse earlier. If, on the one hand, the Selic rate, which reached the historic low of 2% per year, will reach 13.5% per year in our view, on the other hand, it will be 13 months with double-digit inflation. There are palliative relief measures on essential items with regulated prices (fuel and electricity), which increases the risk on public accounts and, in some cases, on the business environment. In the meantime, food prices have already risen 30% since August 2020, directly attacking the purchasing power of the low-income population.

If we believe in the firm performance of monetary policy, it will be possible to have a recession in Brazil from the end of this year until the middle of next year. And we will still be susceptible to the impacts of the uncertain process of global disinflation.

However, the recession will be less acute and more fleeting the more convinced we are that there is no fight against inflation without pain. It is the role of governments to choose wisely for policies that alleviate the suffering of the most vulnerable part of the population, but without rowing against monetary policy. Avoiding an even more costly inflation correction from a social point of view essentially depends on public choices.