Ana Paula Vescovi: Who benefits from a higher inflation target?

Maintaining the schedule of recent years, in June the CMN (National Monetary Council) will define the inflation targets for the next three years. The decision will come after a public technical debate on raising the targets, a change that would tend to be counterproductive for the country.

In 2016, the CMN began a gradual and long-term convergence of the three-year ahead inflation target to the level observed in other emerging economies. In addition to a commitment to reforms that would positively impact the country’s potential growth, the intention was to converge long-term inflationary expectations, which in fact occurred.

Starting in 2019, the inflation targets (4.5%) were reduced by 0.25 percentage points each year, reaching 3% in 2024, where they remained. This convergence takes Brazil’s target to the same level as Latin American peers, such as Chile, Mexico and Colombia.

But a recent debate has arisen over the appropriateness of a central target of 3% for the Brazilian economy. Raising the target again would thus represent the interruption of this convergence and the acceptance of higher price levels. Immediately, more inflation favors public collection and increases the yield on fixed-income investments, but reduces the purchasing power of the population, especially those who commit a larger portion of their income to consumption.

One of the main arguments of those who defend raising the target is that, in addition to inflation having been higher than established in recent years, medium-term expectations have risen, which could be a sign that agents do not believe in their fulfillment. . As such, some would argue that it would be better to elevate the meta to make it believable again.

It is important to remember that the inflationary shocks that have occurred since 2021 resulted from extraordinary events, such as the pandemic and the Ukrainian War, which disrupted consumption patterns and temporarily reduced the supply of goods and services. These shocks are not predictable, and the interest rate instrument can only act, with some lag, on their secondary effects. This confrontation has been successfully carried out by central banks.

In addition, the stimuli adopted by governments to mitigate these shocks contributed to the relative heating of the economy and the labor market, helping to pressure inflation. Therefore, through expectations, raising the target at a time in the cycle when the economy is still showing signs of warming could generate more inflation.

In the case of Brazil, part of the rise in medium-term inflation expectations is related to signals from fiscal policy (more stimuli). That is, it is something that will not be solved by changing the goals.

The change would be a sign of weakening or giving up on the structural solution of the problem that fuels medium and long-term inflationary expectations, that is, the lack of reforms capable of leading Brazil to grow more and rebalance public accounts. However, the government has signaled a broad tax reform —both for goods and services and income and equity—, the adoption of a new fiscal framework capable of addressing the consolidation of public accounts and the advancement of trade integration guidelines with the rest of the country. world, in addition to having a firm commitment to fiscal responsibility, as it had done in the past.

Raising the target would sanction a neutral interest rate —that is, one that neither contracts nor accelerates inflation—higher in Brazil, compatible with the weakening of the reform agenda and with more severe difficulties in the fiscal adjustment. During the full effectiveness of the spending cap and with the approval of the Social Security reform, the neutral real interest rate fell to around 3%, which made possible a neutral Selic rate of around 6% to 7% in nominal terms.

With the paralysis of renovations and the subsequent holes in the ceiling, the neutral rate has been approaching 5% per annum, according to our estimates. By signaling greater leniency with inflation, it could quickly rise to 6%. Would there be any benefit, then, in changing the target?

Those who are in favor believe that this could facilitate the reduction of the Selic rate by the Central Bank and thus mitigate the impact on growth. And, still, that inflationary expectations would be re-anchored in the new target (between 4% and 4.5%).

Empirical evidence, however, shows that the interest rate does not have the capacity to generate growth; it is only able to smooth short-term cycles. So, even if changing the target could generate an immediate drop in the Selic rate, stimulating a faster cyclical recovery, this would come at the cost of permanently higher inflation.

The only factor that can lead Brazil to grow more, without inflationary pressures, is the increase in confidence in a business environment that is safer, more profitable, predictable and less dependent on artificial stimuli, which encourages decisions to consume, innovate and invest.

If Brazil advances in political consensus to approve the necessary reforms, medium and long-term inflation expectations will naturally re-anchor. Risk premiums will be diluted, and the BC will be able to start the Selic reduction cycle.

The only benefit of seeking macroeconomic equilibrium with higher inflation would be to have an inflation tax to help curb some of the expansion of public debt. Something we experienced very recently, after the shocks of the pandemic, which cost a strong loss of purchasing power and a lot of suffering precisely for those who most need the State (the basic food basket rose 58% in this period).

Through the slow, but credible, global inflationary convergence, this is something that will move Brazil away from one of the most basic requirements for attracting investments, by bringing it back to a persistent inflationary context. It is a very difficult and costly place to leave, which intensifies inequality and social instability.