Opinion – Bernardo Guimarães: Is the inflation target too low?

Should the inflation target be 3%? Best 4%? The question is interesting, but there is a lot of confusion in the debate.

It is argued that a lower target would imply higher interest rates. The point seems to stem simply from the Central Bank needing to raise the interest rate to reduce inflation.

However, if we are in a regime with current and expected inflation of 3%, price, salary and contract readjustments will be guided by this index. If current and expected inflation were 5%, the readjustments would be, everything else constant, two percentage points higher.

Thus, keeping inflation at a target of 3% does not require higher interest rates than to keep inflation at a target of 5%. Lowering inflation from 5% to 3% does have a cost (higher interest), but that cost is paid only once, and low inflation continues.

It is said that several academics defend targets around 4% per year in developed countries. It’s true, but why?

The reason is that we cannot have negative nominal interest rates, as nobody is going to buy a security that yields -1% per year (better to leave the money alone). Since the minimum nominal rate is zero, with inflation at 2%, the minimum real (inflation) interest rate is -2%. With inflation at 4%, the minimum real interest rate would be -4%.

The cost of investing is given by the real interest rate. A more negative rate would bring more incentives for investments. In a recession, we might want very low real interest rates.

But how important is this for Brazil? To date, we have never come close to zero interest. Selic’s historic low is 2% per year (reached in 2020).

Some advocate a higher target because the fiscal situation is bad. The larger goal would help the government close the bill in black.

The point is that inflation works like a tax. With inflation of 3%, the R$100 bill will be worth something like R$97 in one year. The difference of R$3 can be seen as a tax charged by the Central Bank.

There is, however, approximately R$400 billion in currency in the economy. If inflation goes from 3% to 4%, the Central Bank collects another BRL 4 billion per year (even assuming that more inflation does not reduce the demand for currency). It’s little water in the ocean of intended fiscal adjustments, of hundreds of billions of reais.

Critics of the higher target argue that inflation is a tax on the poorest. In fact, the poor hold much more cash resources than the rich (as a proportion of income). But a piece is missing from this argument.

There is R$2,000 in paper money per person. How much of that money should be with families? Perhaps a good part of that amount is with sectors of the economy that normally escape taxation – more inflation would tax these agents.

For those who have, on average, R$ 1,000 in currency, 1% more inflation generates an annual loss of R$ 10. The inflation tax is regressive, but 1% more does not affect the fate of those who have little .

Note that higher inflation also makes demand deposits at banks (around R$200 billion) worth less, so more inflation generates a greater transfer of money to banks.

Finally, higher-than-expected inflation reduces the value of the government’s nominal debt, which today is around R$1 trillion. Thus, 1% more unanticipated inflation results in R$ 10 billion for the government.

However, anticipated inflation is incorporated into the price of fixed-rate bonds and has no effect. A higher target is essentially higher anticipated inflation.

In short, an increase in the target to 4% has very little effect on the fiscal situation and only brings some relief to monetary policy in the short term.