The Exchange Rate as an Instrument to Control Inflation

BRAZIL ECONOMICS - Report 03 Jul 2014 by Affonso Pastore, Cristina Pinotti and Marcelo Gazzano

Executive Summary

The Central Bank has been using interventions in the future foreign exchange market as an instrument to control inflation. With the ongoing deceleration of economic growth while inflation hovers near the top of the target interval, Brazil is experiencing a form of stagflation. According to the government’s short-term vision, the worst thing that can happen in these circumstances would be depreciation of the exchange rate.

The interventions in the future market are effective in affecting the spot market. The most effective route is through reduction of the exchange rate risk, enabling gains in carry-trade transactions. Over the past 12 months, more than US$ 30 billion in fixed-income portfolio investments have entered the country, even though Brazil has been running small balance of payment deficits. Without these inflows, it would not have been possible to finance the current account deficits, which are now running at an annualized pace of about US$ 80 billion at the present average exchange rate, and the country would have faced two possible consequences: a weaker real or sale of reserves by the Central Bank.
For the time being, nothing will change. The Treasury yields remain low and the markets have not yet reacted to the worse fiscal policy execution in Brazil. It may well take some time for the Fed to react and for the worsening fiscal policy in Brazil to be clearly perceived, but changes in these respects will put pressure on the real.

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