Neutral Interest Rate and Fiscal Policy

BRAZIL ECONOMICS - Report 20 Jun 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

When all the empirical evidence indicates that inflation expectations are anchored to the target, the Central Bank will begin a monetary easing cycle. Our objective in this report is not to examine when this cycle will start, but rather what the terminal interest rate will likely be. According to Wicksell, the neutral (natural) interest rate is the rate at which investment absorbs all savings at full employment.

It can also be defined as either “the risk free real interest rate such that saving is equal to investment, assuming output is equal to potential output”, or as “the risk free real interest rate such that aggregate demand is equal to potential output”. The two definitions can be found in Blanchard (2022), “Fiscal Policy Under Low Interest Rates”. Therefore, it is clear that the neutral interest rate rises when fiscal policy expands aggregate demand. In addition, although in the United States, Treasuries are considered risk-free public bonds, in Brazil, while there are public bonds free of inflation risk, they are not free of the risk associated with the quality of fiscal policy. This is the case of the NTN-Bs.

The more specific objective of this report is to demonstrate that in Brazil: a) the neutral interest rate has been growing; and b) if at the end of the easing cycle, the Central Bank puts the interest rate at a level that ignores the existence of a risk premium associated with the quality of fiscal policy, the Treasury will not manage to refinance all the bonds that mature plus those necessary to cover the primary deficit, exposing the Brazilian economy to fiscal inflation.

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