At first glance, the idea of an autonomous Central Bank (BC) focused on inflation seems odd. Why should the BC not subordinate itself to the government? And why focus on inflation if BC decisions also affect unemployment and output?
The Central Bank controls the basic interest rate (the Selic), which affects the cost of credit for companies and individuals. Higher interest rates make borrowing more expensive, which reduces the demand for goods in the economy. This eases the pressure on prices (decreases inflation), but also discourages production and sales.
Inflation is also affected by inflation expectations. A company that readjusts prices every six months and expects inflation of 10% tends to choose higher prices than if it thought inflation would be 5%.
Inflation expectations, in turn, depend on our expectations about monetary policy. If we think that the Central Bank will mercilessly raise interest rates to contain inflation in the near future, we expect lower inflation.
Here is the monetary policy dilemma: expectations of low inflation help to contain inflation, so it is good for everyone to believe that the Central Bank will not hesitate to increase interest rates when necessary. But when the time comes to act, we don’t want to be too tough because of the negative effects on employment and output.
Fathers and mothers live with similar dilemmas. It is easier and faster to put away children’s toys instead of convincing them to put them away. But if the children know that they will have to put them away later, they make less of a mess and are less resistant to requests to organize their toys.
So, we want them to believe that they will have to put the toys away, but when it comes to teaching and convincing them, we want to put everything away quickly ourselves. After all, the kids are tired, it’s bath time and I need to write a column for Folha.
To reduce the problem, we can put a poster in the bedroom setting out rules for children to put away their toys. The poster doesn’t put things right, but it does make it harder for us to break the deal and demoralize the house rules.
In monetary policy, the inflation targeting regime plays the role of this poster.
The 3.5% target does not magically determine inflation, but it causes expectations to converge to this value if we believe that the Central Bank will raise interest rates to bring inflation to 3.5%, when necessary. By making disobeying the rule embarrassing, the regime encourages the Central Bank to act tougher when inflation wants to escape the target.
The targeting regime has helped to sustain expectations since its implementation in 1999. Even so, it is an imperfect and especially fragile solution if political pressures can influence the BC to take a more lenient course with inflation. And there?
One solution is to hand over inflation control to an autonomous Central Bank. The arrangement presupposes that the Central Bank would be focused on inflation, as determined by the targeting system. This leads to a tougher monetary policy than we would choose. But, in this way, people and companies come to expect lower inflation, and thus it becomes easier to contain price increases.
This system gives the BC flexibility to react to shocks, but the government loses all power to influence monetary policy.
It may seem strange to dismiss the power to choose, but in this scenario it makes sense.
Fathers and mothers do this, for example, when they throw the child’s pacifiers in the trash. When the baby of the heart despairs, the urge to give the baby a pacifier so he doesn’t cry is too great. Why then throw the pacifier away? Because, if there is no pacifier, there is no point in screaming and crying. Babies seem to understand.
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