Saturday, April 11, 2009

Inflation Target and Recession in Brazil 2009

The fact that Brazil has one of the world's highest interest rates is a puzzling point. The fact that Brazil held high interest rates in the past, when the country was experimenting high/hiperinflation is one thing. However, the Real Plan in 1994 successfully fought against inflation and the country became a stable economy since 1995.

In other words, policy makers in Brazil argued that interest rates had to be high to prevent over-consumption and hence to allow output to grow below potential, which would enable the country to grow at a sustainable pace in the medium run.

Then, in 1999 the Central Bank of Brazil created the inflation target model. According to the model, the Central Bank should not miss the target of inflation (plus a margin of error). If it misses the target the Central Bank loses credibility and inflation expectations should go up. In brief, in a IT framework the goal of the policy-maker is to match the target of inflation using as instrumental variables the exchange rate but more and foremost the interest rate. In this framework interest rates are high because inflation expectations are high. Expectations are formed in the market (either at the Bloomberg consensus or at the Focus survey). With high inflation expectations it becomes harder for the Central Bank to decrease interest rates.

This 'rigidity' of inflation expectations towards the new reality that happened after the Lehman event in October is possibly a major reason as to why the monetary authority did not implement earlier interest rate cuts. Brazil is facing a recession in 2009 mostly because the Central Bank of Brazil decided to follow the market and inflation expectations. It happened, however, that market participants and inflation expectations do not reflect the key economic events that were happening in the US and in the whole world. The crisis was immense and Brazil had to implement more aggressive measures to prevent the key impacts of the financial crisis in Brazil. In turn, the monetary easening started too late to prevent a contraction in output in Brazil in 2009. In brief, in times of crisis and turmoil, inflation target models with narrow focus on CPI inflation as a monetary policy target should be abandoned.

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