Fiscal Expansion and the Monetary Policy Error of 2019

BRAZIL ECONOMICS - Report 18 Sep 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

With the unemployment rate below 8% and strong expansion of household consumption, Brazil’s economy can only be classified as heated. But in light of the looming difficulties of meeting the primary result target for 2024, the government wants to maintain GDP growth, with a corresponding increase of revenues. It also wants the Central Bank to “collaborate” with this objective by keeping the real interest rate as low as possible.

In this Report, we analyze this conflict and sound a warning. Well before the pandemic, between July and December 2019, the Central Bank had seemingly completed a monetary easing cycle that put the SELIC rate at 4.5% a year, with the one-year ex ante real rate (the DI for one year deflated by expected inflation 12 months ahead) at 1%, below all estimates of the neutral real interest rate. But the cycle did not end at that point. Without interruptions, then reacting to the effects of the pandemic, the Central Bank lowered the SELIC rate at all subsequent COPOM meetings until the nominal rate reached 2%, with the one-year ex ante rate dipping into negative territory.

Besides the comparison between the real interest rates and the estimates of the neutral rate, we rely on two metrics to reveal that the Central Bank in that period erred on the dovish side. The first consists of a comparison between the exchange rates of the real versus the dollar and the median of the currencies of a representative sample of advanced and emerging countries, with the real depreciating much more than any of the other currencies. The second involves estimation of the implicit inflation rate target, showing that as happened in 2011, the Central Bank did not aim at the central target, but instead at an implicit inflation rate higher than the midpoint of the interval.

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