Effects of the Fiscal-Monetary Conflict

BRAZIL ECONOMICS - Report 22 May 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

Whether measured by the one-year ex-ante real interest rate or by our financial conditions index, monetary policy is more restrictive than during the recession of 2014-16. Nevertheless, the economic activity data for the first quarter of 2023 show that the economy, at least until then, was recovering vigorously, a movement that began at the start of 2022.

How can this paradox be explained? The answer is very simple: the ongoing conflict between expansionary fiscal policy and restrictive monetary policy. Since the only guarantee provided by the new fiscal framework is higher spending, fiscal policy will remain expansionary for the time being, reducing the efficacy of monetary policy. On the other hand, the Central Bank is unlikely to yield to pressures from the government to increase the interest rate prematurely.

With continuation of restrictive monetary policy, with activation of the credit channel, unless the government reacts with new stimulus instruments, including the use of public banks to promote expansion of demand, the second half of 2023 will be marked by slower growth, which will help to reduce inflation. The Central Bank will only start an easing cycle when the conditions to anchor inflation expectations to the target are met.

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