Exchange Rate, Risk and Monetary Policy Reaction

BRAZIL ECONOMICS - Report 12 Sep 2016 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

Up to the early weeks of 2016 the quotations of Brazil’s CDS rose simultaneously with steep depreciation of the exchange rate. The exchange rate is an asset price, reacting strongly to expectations. For this reason, as the perceived chances of impeachment increased, the depreciation movement inverted, accompanied by an accentuated decline of the risk premiums. Now that the impeachment has been confirmed, from here on signs of progress toward fiscal adjustment will tend to strengthen the real even more, but to the extent the Central Bank reacts by cutting the interest rate, it will be simultaneously reducing the attraction of capital inflows and encouraging fixed capital investments, prompting an increase in the current account deficit. Since capital movements happen faster than adjustment of the current account, initially appreciation will predominate, helping to curb inflation and strengthening the arguments for reducing the interest rate.
In a world characterized by price rigidity, movements in the nominal exchange rate are closely reflected in the real exchange rate, so they interfere in the competitiveness of exports and with the stimuli for substitution of imports. If no shocks occur that raise risks and cause large swings in the nominal exchange rate, the path of the real exchange rate will be less volatile. This is shown by the projections based on our real exchange rate model, which relies on the terms of trade and net external liability as explanatory variables.

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