The Crisis and the Conflict Between Fiscal and Monetary Policies

BRAZIL ECONOMICS - Report 26 Oct 2015 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

Brazil is not experiencing a balance of payments crisis: the current account deficits have been shrinking sharply and the reserves are plentiful. What exists is interplay of fiscal and political crises. The government does not have the strength to achieve the fiscal adjustment necessary to curb the explosive growth of the gross public debt.

The growing risks related to the debt dynamic have been causing the real to depreciate, and inflation has been rising even though the pass-through to prices is low because of the recession (which is deep and will not end soon). In the early months this year, there was some belief that the new finance minister would be able to achieve the miracle of delivering the professed primary surplus target of 1.1% of GDP in 2015, and an even better 2% in the following years. This calmed the markets, helping the Central Bank, whose reaffirmed commitment to bring inflation to the 4.5% target started to reduce inflation expectations, causing a steep negative slope of the yield curve.

It appeared the Central Bank was redeeming itself from the gross error committed in 2012, when without any justification it started lowering the SELIC rate, only to reap higher inflation and unanchoring of expectations. But it has received the castigation of a fiscal shock, which radically changed the situation. The announcement that the government would not meet the primary surplus target was followed by a budget bill sent to Congress containing a deficit in 2016. The complete fiscal loosening – largely fruit of the critical erosion of governability – has caused chaotic movements of expectations. The gradual reestablishment of anchoring that marked the first months of the year has now given way to sharp upward shifts in the entire yield curve, with a positive slope, reflecting a rise in inflation and risk premia.

The Central Bank has had to change its discourse again, indicating monetary accommodation. It will have to be very careful to avoid submission to fiscal dominance. But even if it succeeds in this respect, the most probable outcome is that inflation will remain very high in the next few years.

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