Opinion – Why? Economês in good Portuguese: Monetary policy and inflation targeting

The story went like this: we abandoned (were we forced to abandon?) the system of semi-fixed exchange rates in 1999, after a sequence of international crises, and for the cow not to go to the swamp it was necessary to immediately put a new and credible framework in place , in order to prevent accelerated inflation in the style of the pre-Plano Real period.

It was then that they called Arminio Fraga, who brought the inflation targeting system to Brazil. Along with an imperfect (but done) fiscal adjustment, we’ve kept prices in check. It can therefore be said without much controversy that the adoption of inflation targets was a success. And it gained an additional pillar with the recent formal independence of the Central Bank.

And what does this arrangement consist of? In a formal obligation on the part of the monetary authority to keep inflation within a certain pre-specified range and to provide the paying public with transparency for the processes and decisions aimed at achieving this target. Producing reports, maintaining direct communication with society, explaining decisions about interest rate changes, visiting Congress, producing analytical studies, etc.

Why all this paraphernalia? To give more credibility to the monetary authority and increase its commitment to the established objectives. Makes sense? Yes, because that makes the very task of keeping inflation low and stable less painful for society. The targeting system is designed to anchor inflation expectations. And this anchoring, when achieved, makes the task of delivering final inflation within the target or close to it easier.

That said, what is the ideal inflation? What should the goal be?

The first point that needs to be clarified here is the following: higher targets do not magically help the economy grow more. They may indeed bring some momentum in the short term, but it’s always a chicken flight, the shortest kind. The poor reader must have read this more than once, but here it goes again: there is no trade-off between inflation and long-term growth. The naive argument is that, by increasing the target, the Central Bank does not need to be so tough when it comes to raising interest rates. It’s not like this.

When the target is raised, expected inflation does not sit still. She goes up too. And then the Central Bank needs to raise interest rates by the same amount. Or even more, if the change is understood as: “When times are tight, this group raises the inflation target, so what will prevent them from raising it again in the future?”. If this questioning takes hold, and there is a good chance, things will go away. So better not mess with that wasp nest right now.

The problem is essentially one of credibility. If the government were planning a strong fiscal adjustment, giving clear signs that the Central Bank will not suffer the slightest pressure from the Executive, that the reform agenda will go ahead, etc., we could even enter into the debate about 4% or 3%. But, at a time when we are experiencing the opposite of that, it would be a heavy caliber shot in the foot. The clear absence of political will in the fiscal arena and the perception of the markets that the real Minister of the Economy is President Lula are already leading to increases in inflation expectations and risk premiums. Time to reinforce the BC’s independence and to accept the 3% target.

The academic debate about the ideal goal is valid. There are reasons discussed in the literature, for example, to prefer 4% to 2% as a target. The 4% makes it less likely that an economy will reach the lower limit of 0% interest rate that made life so complicated in some rich countries in times of crisis; in addition, they add a little more oil to the gear at the time of an adverse shock, given that nominal variables are very difficult to adjust and inflation can help to do this service in a less traumatic way.

In the current circumstances of the Brazilian situation, however, it is not even a question of the controversial 2%, and we do not run the risk of reaching the minimum limit of nominal interest of 0%. In practical terms, it is even better at this point to adhere to the saying that “the best can be the enemy of the very good”, putting this debate aside and focusing on the fiscal area.