The government can still reverse the boomerang effect on expectations of the new inflation target
Heightened uncertainty about monetary policy after the change in the inflation target has increased expected inflation for 2018; however, the government can still reverse the undesired effect of this new inflation target (15% per year), announced on December 28.
The President of the Central Bank has not yet changed the way he describes future monetary policy, even though the announcement meant a clear acknowledgement that controlling the interest rate paid on LEBACs is not enough to reduce the inflation rate.
What was perceived as an inconsistency between the description of future monetary policy and the decision on the interest rate paid on LEBACs adopted after the announced change in the inflation target has amplified the uncertainty about the government’s strategy to fight inflation.
Our interpretation is that since December, the government, not just the Central Bank, has decided to pursue the new inflation target with several instruments, not just monetary policy.
The 2018 budget approved by Congress sets a binding limit on the expansion of primary government expenditures, at 16% compared with 21% in 2017. The government will work hard to assure that the increase in public sector salaries does not exceed 15% in 2018, and that the average increase in salaries negotiated by private employers and the trade unions will not significantly exceed the 15% target for the 12-month period from April 2018-March 2019.
Most of the adjustments in regulated prices will be completed by April 2018, except for urban transportation in the Greater Buenos Aires area. Therefore, the government will be able to announce in April that, in the future, most regulated prices will be adjusted in line with target inflation.
We also think the government will try to keep the nominal exchange rate depreciating at a pace not exceeding the 15% inflation target. If the reduction in the rate paid on LEBACs induces a higher rate of depreciation of the peso, we predict the Central Bank will intervene in the FX market to prevent further depreciation. It has the reserves to manage that kind of FX intervention if most other remaining variables are kept in line with the inflation target.
Unfortunately, the market does not seem to attach a high probability to all these actions’ becoming a reality. But if the government changes the way it explains its stabilization strategy and decides to make clear that it will complement monetary policy with all those other instruments, expectations may change to move closer to the inflation target announced on December 28.
The course of inflation in December 2017 and January 2018 and the significant devaluation of the peso should not discourage the authorities from insisting on its new inflation target. In this report we explain why.
Furthermore, the signals coming from the external financial markets, particularly those in the US, will also put pressure on the government to stick to its commitment to contain government expenditure and encourage competitiveness via productivity increases and, of course, avoid an excessive real appreciation of the peso.
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