Opinion – Samuel Pessôa: Inflation, inflation expectations and the exchange rate

It has been common for people to claim that the Central Bank should not fight inflation because it is the result of supply shocks that will dissipate.

It is a fact that inflation came about that way. But the biggest sign that inflation today is no longer the result of supply shocks is that services excluding airline tickets ran in the last three months at 5.7% (index in 12 months). And the core of services, which disregards the most volatile items, rotated, in the last three months, at 6.1%, above, therefore, the inflation of free prices, which rotated, in the same three months, at 5.8%.

That is, those inflation items, such as services, that are not directly affected by supply shocks have been running well above the target.

Additionally, the job market is very tight. As I have discussed in other columns, we are probably at full employment.

To make matters worse for the BC, inflation expectations 12 months ahead, collected by the Focus survey conducted weekly by the monetary authority, have been rising and closed January at 5.4%, well above the target. Still according to Focus, the expected inflation between August 2023 and July 2024 is at 4.4% —again, well above the target.

There is an argument that the Focus survey is conducted by the BC with economists who work in the financial market. Inflation would therefore be a self-fulfilling prophecy. In this view, market economists want interest rates to be high in order to earn more money. Thus, they respond to the survey by overestimating inflation, and, as everyone ends up assessing that inflation will rise, it ends up rising.

This thesis makes no sense, as consumer expectations, as surveyed by the Consumer Survey conducted by FGV Ibre, essentially behave like Focus expectations. It presents the same trends, with the difference that the inflation expected by the general public is always higher than the inflation expected by economists working in the financial market.

That is, interest rates are high because inflation is high and unanchored. Expectations signal that inflation will not reach the target in the visible horizon.

Changing the subject, last week I presented some accounts that indicated that the real, between October 19 (before, therefore, the elections) and February 2, appreciated by R$ 0.23 against the dollar. I used synthetic control methodology with other currencies and argued that, if it weren’t for Lula’s talk, the valuation would be even greater. Instead of R$5.04, the real would be quoted, on February 2nd, at R$4.8.

Readers have criticized me, claiming that the choice of control groups was not systematically and statistically correct. The criticism is partly correct. It’s a simple methodology suitable for a Faria Lima professional who has to conduct a macro scenario meeting every week.

Livio Ribeiro, my colleague from FGV Ibre, came to my rescue and redid the calculations, for the same window of 10/19/22 and 2/2/23, using a fundamentalist model for short-term determination of the exchange rate. The hypothesis of the exercise is that the variation in country risk and its impact on the exchange rate that is not due to international factors is due to domestic turbulence. The exercise obtains results in line, in fact a little more intense, with those obtained with synthetics.

Thus, it seems that, effectively, Lula’s verbal incontinence has exacted a price in the form of currency devaluation. In fact, the closing of the exchange rate on Friday (10) above R$ 5.2 indicates that the problem persists.