The Fiscal Disaster and Monetary Policy

BRAZIL ECONOMICS - Report 30 Nov 2015 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

There is little hope of any improvement in the fiscal picture: the most recent numbers reveal that over the past 12 months, the central government has accumulated a recurring deficit of more than 1% of GDP; the recession continues to erode revenues; and there is no political support for approval of measures that could assure even a modest primary surplus, such as the CPMF levy.

We show in this report that Brazil is not in a fiscal dominance situation, where the effects of monetary policy are inverted: elevation of the interest rate still does not lead to higher inflation. Nevertheless, the worsening fiscal picture is causing the exchange rate to weaken, which raises inflation, and if the Central Bank reacts by hiking the interest rate it will worsen the recession, producing an additional decline in revenue and thus aggravating the fiscal problem. To minimize the need for monetary tightening, the Central Bank has been intervening in the future foreign exchange market, even though the efficiency is limited.

The reduced efficacy of monetary policy is an additional reason to carry out a profound alteration in the fiscal policy field. Over and above a simple adjustment, radical reforms in the fiscal regime are needed in order to generate surpluses in the foreseeable future, enabling the government to meet its intertemporal budget constraint. In the political realm we are very far from such solution.

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