Mauro Rochlin: Interest, inflation and elections

The inflation rate, measured by the IPCA, reached the 10% mark in 2021. It is the second time in almost two decades that the indicator has reached double digits.

Despite this bad result, the forecasts for this year are better. The Central Bank’s Focus report, a harbinger of the financial market, predicts that the 2022 rate will be around 5%.

In Brazil, the strategy to combat inflation is focused on the deterrent power of monetary policy. Since 1999, the country has adopted an interest rate policy known as the Inflation Targeting Regime (RMI). The premise of this model is that the interest rate on government bonds —the Selic rate— is the main instrument of anti-inflationary policy.

The argument is that the attractiveness of these bonds affects the population’s decision to consume (or save), which has a strong impact on price behavior. The model relates the rise in interest rates to the fall in consumption, and, consequently, to the fall in prices.

Based on this assumption, the Central Bank started, in May of last year, a cycle of increase in the Selic rate. Starting from a level of 2%, the rate already reaches a value above 10%. The idea is that this increase cools down consumer pressures and that this helps to control prices.

In fact, GDP (Gross Domestic Product) figures for the third quarter of 2021 already point to an accommodation in household consumption. This is expected to translate into downward pressure on prices, corroborating market forecasts.

The problem here is the other side of the coin: high interest rates also lead to lower economic growth and higher unemployment.

Despite inflation having registered a poor result in 2021, the RMI has achieved, throughout its term, a relative success. In the 22 years since its adoption, the regime has helped keep inflation within target on 16 occasions.

Product of the implosion of the fixed exchange rate system, which served as a price anchor in the first years of the Real Plan, the RMI has a history: it resisted two exchange rate crises (1999 and 2002) and three economic crises (2009, 2015 and 2020).

Even in the face of these good results, the model faces strong criticism. Despite the eventual fulfillment of inflation targets, the regime is also associated with mediocre economic growth. Since its implementation, the average GDP growth rate has been around 2% per year.

A permanently high interest rate accompanies this poor performance. On the employment side, the scenario was only better during the commodity boom cycle.

To reduce the pressure on monetary policy, the adoption of a less wasteful fiscal policy would be essential. Moderating government spending would help to balance consumption and calm the foreign exchange market.

With the reduction in demand and the fall in the dollar, prices would tend to stabilize. This stability, in turn, would make room for a consistent drop in interest rates, which would boost GDP growth. From that context, a virtuous circle could thrive.

The electoral race has been a hotbed of overly generous public policies. Electoral goals have inspired fiscal arrangements by several governments. While the current scenario recommends moderation and restraint in fiscal policy, what is observed are initiatives, such as the PEC dos Precatórios, which circumvented the so-called spending ceiling, pushing in the opposite direction.

Ignoring the basic rules of fiscal responsibility can overwhelm interest rate policy and, consequently, hold back economic growth. It doesn’t seem like a good idea.