The Central Bank and The Red Queen Syndrome

BRAZIL ECONOMICS - Report 18 Apr 2022 by Affonso Pastore, Cristina Pinotti and Paula Magalhães

With the one-year ex ante real interest rate at (or slightly above) 7%, nobody can accuse the Central Bank of being lenient with inflation. However, it is necessary to recognize that as of the start of the pandemic, the Bank has been behind the curve, allowing expectations to become unanchored. This criticism is not aimed at the reduction of the SELIC rate to 2% at the start of the pandemic. After all, that was a situation of radical uncertainty (as defined by Mervyn King, in his book of the same name, published in 2020).

The critique is directed to the period of forward guidance, followed by a commitment to an “only partial” elevation of the interest rate (meaning the movement would stop before the rate reached the “neutral” level). When the Bank finally professed it would do “whatever necessary”, it was repeatedly surprised by inflationary shocks (oil and other commodities) that fed inflation and resulted in progressive unanchoring of expectations. With the one-year ex ante real interest rate at around 7% (above the neutral level), the inflationary effects of those shocks should dissipate, but this effect is counterbalanced by both the positive fiscal impulse (requiring an even higher real interest rate) and the perception that the Bank’s reaction curve gave (much) greater weight to economic activity than had been the case under the Bank’s previous directors.

The Bank never abandoned the goal of reaching the target, but aimed to do so very gradually, exposing it to the red queen syndrome, of running just to stay in the same place. The upshot is that inflation will start to decline this year, but only very slowly, and the inevitable reliance on the aggregate demand channel will likely mean a recession starting in 2023. Given the carry over from 2021, the effects of the fiscal impulse, and the resilience of the service sector, it is unlikely this recession will start before the elections, in light of the stylized facts of a political cycle in an election year.

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