The Neutral Interest Rate and Fiscal Policy in Brazil

BRAZIL ECONOMICS - Report 22 Aug 2022 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

It is known that economically mature countries tend to have low neutral interest rates. The causes are also known, ranging from the demographic transition to the lower investment rate, and it is necessary to understand how monetary policy operates when the interest rate in equilibrium approaches the zero lower bound. For Brazil, extensive empirical evidence exists about the decline of the neutral interest rate, but the reasons given are not the same.

The objectives of this report are to demonstrate that both the declining trend and fluctuations of the neutral interest rate are a consequence of fiscal policy; and to examine some of the consequences. Based on its independence in using the monetary policy instrument – the basic interest rate – the Central Bank can set the inflation target either according to a low or high neutral interest rate, but what determines whether this rate is high or low is fiscal policy. In the years when the country’s fiscal framework was on the road to consolidation, with the approval of the Fiscal Responsibility Law and the generation of primary surpluses that were reducing the debt/GDP ratio (enabling the country’s promotion to investment grade rating), the yields of the NTN-Bs were falling steadily, accompanying the estimates of the decrease of the neutral rate.

When the government adopted the “spending is living” fiscal policy, the neutral rate resumed rising, only returning to the downward trend when the enactment of Constitutional Amendment 95 imposed obedience to the intertemporal budget constraint. Since the waning days of the pandemic, however, the pieces composing Brazil’s fiscal framework have been diligently destroyed, with the consequence being elevation of the real interest rate accompanying the rise of the neutral real rate. From here on, two paths can be taken. The first would be resumption of the earlier trend, of progressive improvement of the fiscal framework, with all its positive consequences. The second is to formulate arguments seeking to legitimize a loose fiscal framework. Despite the negative consequences, this route unfortunately has the support of many.

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