Opinion – Why? Economês in good Portuguese: What does a government program need to contain in monetary policy?

In 2022 we will have presidential elections. The discussion on economic policy is still at a very early stage. We still don’t have all the candidacies defined, nor government programs. However, we already know a good part of the dilemmas of the Brazilian economy, and what these eventual programs would need to contain.

Last month, we started a series with this motivation, initially addressing the issue of public accounts or fiscal policy. In this text we continue the discussion, this time talking about monetary policy.

How does monetary policy work?

Monetary policy is the responsibility of the Central Bank, which controls the amount of money in circulation. Like most central banks in the world, Brazil’s monetary policy uses an interest rate target. The Central Bank adjusts the amount of money in the economy in order to reach a certain value for the basic rate, known as the Selic. And it ends up influencing other interest rates in the economy.

The Central Bank’s main mission is to maintain price stability. In Brazil, this is done within the inflation targeting system. The one-year target is determined in advance by the National Monetary Council. In general, there is a target center, and a tolerance range. For 2022, for example, the target center is 3.5%, with 1.5% tolerance up and down.

The Central Bank then needs to adjust its monetary policy to keep inflation closer to the target. If inflation is too high, it tends to raise the Selic rate. This pulls up other interest rates, which discourages consumption and investment. Economic activity cools down, making it harder for producers to raise their prices, which contributes to lowering inflation. On the other hand, when inflation is very low, the Central Bank tends to do the opposite, reducing the interest rate.

In the face of high inflation, a rise in the Selic may also signal that the Central Bank is concerned about price stability. This helps to adjust inflation expectations downwards, causing producers to start raising their prices less today, contributing to lower inflation.

So we can expect discussions, among the candidacies, around the Selic rate. Some presidential candidates may argue that the Selic rate is too high, and needs to be reduced to encourage the economy and generate jobs. Others may still say that the Central Bank is too “lax”, and that it needs to shock the Selic to tame inflation.

None of this will be possible, at least not immediately.

Recently, the National Congress approved and President Bolsonaro sanctioned a law that guarantees autonomy to the Central Bank. In particular, the president and a good part of the directors of the institution started to have fixed terms of four years, not coinciding with those of the president of the Republic. This implies that the next Chief Executive will inherit almost the entire board of the current Central Bank. Substantial changes would only be possible in the middle of the president’s term.

In addition, the inflation target is already determined in advance. In other words, the next president of the Republic will be able to do little, at least directly, to change the course of the Selic in the short term. Promises of radical drops in interest rates, by magic, are empty.

To get around this issue, the presidential candidate could promise to end the autonomy of the Central Bank. But this does not depend only on the President of the Republic, as it requires congressional approval. And it would bring up an additional question.

The point of the Central Bank’s autonomy is to shield the institution from political pressures in the definition of monetary policy. The president’s move in this direction, especially if he wants to lower the Selic, would already raise inflation expectations. This would cause a portion of producers to begin to readjust their prices in anticipation, bringing more inflation, and making it difficult for the Central Bank to maintain price stability. He would likely have to raise the Selic, leading to the opposite result.

But does all this mean that there is nothing the new president can do?

No. Monetary policy is not effective in controlling inflation without tidy public accounts. If the government consistently spends more than it takes in, and its debt grows out of control, there is an increasingly likely scenario in which the government will print money to pay its bills, even with a central bank on autonomous paper. And that would bring high inflation down the road. The consequence is an increase in the expectation of inflation in the present.

We have already witnessed a movement in this direction recently, with the PEC of Precatórios and the relaxation of the spending ceiling rule. The prospects for public accounts worsened, the risk of Brazilian public debt increased, and inflation expectations for 2022 rose. The Central Bank reacted, tightening the pace in the rise of the Selic.

If we want to have lower interest rates and inflation, the next President of the Republic and the National Congress will need to address this issue of public accounts. Probably thinking about a new rule that guarantees sustainability for government debt. This is something government programs need to address.

Mauro Rodrigues (professor of economics at USP and author of the book “Under the magnifying glass of the economist”) and the team at Por Quê?