Almost three weeks after the election, we still don’t have a definition of who will be the Minister of Economy or clues about proposals on how we will rebuild a credible fiscal rule that will allow for the stabilization of the public debt. Furthermore, we have, so far, no signs that we will organize the 2023 Budget based on fiscal responsibility.
In the face of this scenario, financial assets reacted negatively —the Ibovespa plummeted, the real depreciated and future interest rates soared—, against the grain of the external market, which appears to be more favorable after an easing of US inflation and more positive news from China.
Even foreigners, mostly more confident with the country, began to question the wisdom of bringing more uncertainty at the beginning of a government that had promised credibility, predictability and stability and how this would tend to hinder the work of the Central Bank.
Until election day, it was expected that Brazil would be one of the first countries to start the cycle of falling interest rates, even with strong activity. We are no longer in that “queue”. With the feeling of a lack of a credible fiscal anchor remaining, it is more likely that the next movement of the future yield curve will be pricing in a rise in rates for the beginning of next year.
It is not new that fiscal policy interferes with monetary policy. The first channel is that of aggregate demand —a new fiscal stimulus in an economy that is without idle capacity and with core inflation well above the target requires more restrictive interest rates. The second is the loss of fiscal balance, which generates an increase in the risk premium, exchange rate depreciation and discouragement of inflation. There is also the channel of an aggressive quasi-fiscal policy, with the intensive use of BNDES and public banks to subsidize credit, which reduces the power of monetary policy.
The BC’s concern has already been present in its communication for some time and was reinforced in the minutes of the most recent Copom meeting, through two alerts: “The committee assesses that the permanent increase in expenses and the uncertainty about its trajectory from next year may raise the country’s risk premiums and inflation expectations” and “noted the greater sensitivity of markets to fiscal fundamentals (…) concomitant with the tightening of financial conditions, [o que] inspires greater attention to emerging countries”.
For the first time in our history, the Executive Branch will alternate with the autonomous BC. Incidentally, this is the only stabilizing factor at this point. Without the approval of Complementary Law nº 179, speculations about the appointment of the new president of the Central Bank would certainly bring more volatility, with the uncertainty regarding the course of monetary policy adding to the fiscal uncertainty.
It is true that Brazilian inflation has dropped significantly in recent months —albeit largely due to tax cuts—, bringing less inertia to 2023. We are already seeing an incipient qualitative improvement in inflation. But, if even without a confidence crisis it would be challenging to have some components of inflation, such as services, decelerating in the midst of an economy boosted by fiscal stimuli, with a crisis this scenario is difficult to happen.
When a country’s fiscal anchor is lost, inflation expectations are completely unanchored, and even if fiscal disorganization results in a recession, the most likely result is a process of rising inflation.
If the BC is forced to react to the loss of the fiscal anchor, raising interest rates, we will move towards a process of fiscal dominance.
When the Central Bank raises interest rates to try to contain inflation, additional public spending increases the necessary inflation to stabilize the public debt. This is because —without fiscal brake mechanisms— inflation becomes the solution to the solvency problem.
First, by increasing nominal GDP, which enters the denominator of the debt/GDP ratio; and, second, because it causes some improvement in the primary result, since revenues are more indexed than expenditures.
A vicious cycle of increased risk premium and inflation makes monetary policy ineffective and transient in the process dominated by the fiscal problem.
We experienced a similar situation in 2015, but the current difference is that we have a credible BC that has just won its formal autonomy. If the new government’s choice of economic policy puts us in fiscal dominance, the Central Bank will have to act without hesitation, even so that there are no doubts that this institution has autonomy in fact, not just in law.