The Monetary Policy route
It has long been known that monetary policy decisions must consider the conditions coming from fiscal policy. What is the likelihood attributed by the market to approval of a robust pension reform – the most important condition necessary to guarantee fiscal consolidation? Looking at asset prices we would say that the probability is high, but political occurrences last week have cooled the optimism somewhat. If against a backdrop of weak economic growth, the Central Bank were to cut the SELIC rate without the proper backing from fiscal policy, the positive slope of the yield curve would steepen, leading to an increase in the one-year real interest rate (the most relevant rate for economic activity). In this case, instead of increasing the monetary stimuli and hastening the closing of the GDP gap, these stimuli would be reduced. To increase the monetary impetus (with faster closing of the GDP gap and convergence of inflation to the target), the decline of the SELIC rate will have to lead to a lower one-year ex-ante real rate, which depends on assurance that the fiscal consolidation process is under way. The conclusion is that the next steps of monetary policy depend simultaneously on: a) the decisions related to fiscal consolidation, in particular the pension reform package; and b) the pace of economic recovery.
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