Campos Neto will write the 6th letter from a BC president to justify off-target inflation

When inflation ends the year outside the established range, the president of the BC (Central Bank) needs to justify the reasons in an open letter and detail how the problem should be resolved.

The target is defined by the CMN (National Monetary Council) and it is up to the BC to fulfill it, especially through the calibration of the Selic, the basic interest rate.

The current head of the monetary authority, Roberto Campos Neto, will write the sixth letter since the creation of the inflation targeting system, in 1999. The text, addressed to Minister Paulo Guedes (Economy), needs to be disclosed after the release of the IPCA ( Broad National Consumer Price Index) for December, which brings the closed data for the year.

In the last inflation report, the BC pointed out a 100% probability for the 2021 target ceiling to be exceeded.

The expectation is that the indicator ends 2021 above 10%, almost double the target ceiling. The target today is 3.75% with a tolerance of 1.5 percentage points upwards or downwards, and may reach a maximum of 5.25%.

The most recent letter was written by Campos Neto’s predecessor, Ilan Goldfajn. The text was related to the 2017 inflation, but, at the time, the BC president was justified in letting inflation fall slightly below the established minimum limit.

That year, the index stood at 2.95%, compared to a target of 4.5% with a tolerance of 1.5 percentage points lower or higher. Prices could have been between 3% and 6%. Selic ended the period at 7%.

According to the document, the main reason for the strong deceleration in inflation was the 4.85% drop in food prices (deflation) at home, precisely the item that started the series of cost shocks that led the 2021 indicator to two digits.

The other letters were written in 2015, 2003, 2002 and 2001, all because of having exceeded the upper limit of the inflation target. The reasons were diverse and included devaluation of the real, investor confidence crisis, global crisis and realignment of prices that were repressed.

Since the implementation of the regime, all BC presidents have had to justify the non-compliance with the inflation target.

Longest running mandate so far, Henrique Meirelles was the only one to have to write two letters during his term, from January 2003 to December 2010, eight years in all. But the previous scenarios were different from the current one, the economists point out.

“The 2015 letter highlights that in the middle of the year, market expectations were already showing convergence for 2016, which is totally different from what we see now. Despite the BC’s effort to increase [a Selic] 1.5 percentage points at each meeting, expectations are unanchored [para os anos seguintes]. This is very impactful because it shows that maybe I have to go beyond [nos juros]”, compares André Galhardo, the chief economist of the Economic Analysis consultancy.

In the last decision, on December 8, the BC’s Copom (Monetary Policy Committee) raised the base rate again by 1.5 percentage points, to 9.25% per year. In the statement, the BC indicated a new high of the same magnitude for its next meeting, in February, to 10.75% per year.

Galhardo also considers that this is the first letter written after the BC’s autonomy, which defined objectives secondary to the autarchy. In addition to inflation, which remains the main attribution, the official needs to look at economic activity and the labor market.

“Even if it has made it clear that price controls are the main target, the BC will have to give some satisfaction in relation to the level of economic activity and put this in the letter without causing any surprise to the market”, points out the analyst.

For economists consulted by leaf, the letter is just a formalization of the justifications that have already been disclosed in official communications, such as the Copom decision, the minutes of the meeting, the inflation report and public speeches by the president and directors of the autarchy.

Based on these documents and speeches, Campos Neto should cite the successive cost shocks, which began with the shift in demand for food in the Covid-19 pandemic. People stayed at home and food at home became more expensive.

Then came problems in crops due to weather events, rise in commodity prices accompanied by devaluation of the real, rise in fuels and the water crisis, which made the Brazilian electricity bill more expensive.

“The justification must contain the shocks and any mismatch in the supply chain caused by the pandemic”, highlights the chief economist of Ativa Investimentos, Étore Sanchez.

Although the BC has attributed part of the lack of control in inflation expectations to fiscal risk in official communications, Sanchez says he does not believe that the letter places much emphasis on public accounts. “The market’s perception of a loss of credibility in the fiscal anchor affected expectations for future inflation, but current data were better than expected,” he points out.

“The letters tend to be very succinct, not to give too much guidance [sinalização de passos futuros]. It’s important not to generate misunderstandings,” says Sanchez.

The chief economist at JF Trust Investimentos, Eduardo Velho, bets that the BC should bring the fiscal deterioration as a justification.

“Certainly, they will have to admit the deterioration of fiscal policy, with postponement of privatizations, the threat of non-compliance with the spending ceiling rule, which was only recently eliminated, and the prospect of lower future growth. Higher interest rates and less revenue in 2022 should sanction a larger primary deficit and a greater reaction from the interest rate adjustment. This was reflected in the rise of the dollar and the demand for hedge [proteção cambial]”, puts the economist.

Chief economist João Beck, economist and partner at BRA, an accredited firm of XP Investimentos, emphasizes that the letter must contain the justifications already disclosed by the monetary authority.

“The BC is already justified at all times, in the communiqué that comes out with the decision, in the minutes of the meeting, in the inflation report, to the TCU [Tribunal de Contas da União] and to the Senate. What comes in the letter is usually an extension of things that have already been said,” he says.

In addition to the shocks, Beck ponders that the BC took the basic interest rate to the lowest level in history, at 2% per year in August of last year and maintained the level until March of this year. The excessively stimulating level, according to him, was accompanied by the BC’s communication that inflation was temporary, which led expectations to rise throughout 2021.

“The whole world believed that inflationary pressure would be temporary, not just Brazil. That’s because it was believed that it would be an economic depression, but it wasn’t. That’s why interest rates were greatly reduced,” recalls Beck.

The market’s assessment is that the monetary authority took a long time to notice the persistence of inflation, which was qualified as temporary for months on end, and when interest rates started to rise, it gave wrong signals that the monetary tightening would not be as long or as intense. The conduct of monetary policy must be one of Campos Neto’s justifications.

The rise in prices was more persistent than expected and also contaminated expectations.

In his speeches, however, the BC president defends that the Selic rate was raised to 2% a year in view of the projection of a scenario that did not materialize, with a drastic drop in GDP and the risk of deflation.

“The letters are usually mere repetitions of what we saw in the press releases and in the minutes. The big thing this year is the issue of the Selic having reached 2% a year, you will have to justify if it took a long time to start the high cycle and already there is a risk of inflation breaching the target ceiling next year,” points out Galhardo.