What Should be the Reaction to the Appreciating Exchange Rate?

BRAZIL ECONOMICS - Report 01 Sep 2016 by Marcelo Gazzano, Cristina Pinotti, Caio Carbone and Affonso Pastore

Even without growth of capital inflows, the real has been getting stronger, and that trend will likely accentuate with reaffirmation of the commitment to carry out the fiscal adjustment now that impeachment has been confirmed. The strengthening of the nominal exchange rate has been affecting the real exchange rate and has started to elicit complaints and requests for interventions.

Small interventions aimed at damping volatility are virtually cost-free. But this is not the case of intense interventions (either in the spot or future market), especially when the objective is more ambitious: to set targets for the exchange rate. In this Bulletin, we look at two historical examples: one between 2006 and 2010, when heavy interventions occurred in the spot market; and the other starting in May 2012, when the interventions have been concentrated in the future market. In both cases the fiscal costs were high, leaving the lesson that in the current circumstances of the Brazilian economy – of profound fiscal maladjustment – strong interventions would be unwise.

Under the current circumstances, the best reaction by the Central Bank would be to cut the interest rate, obtaining two effects: reducing the attraction of foreign capital; and together with the decline of risks due to the fiscal adjustment, stimulating fixed capital investments, leading to higher current account deficits. On one side this would reduce the supply, while on the other side it would increase demand for foreign currency, easing the pressure for appreciation.

But the road faced by the Central Bank is not smooth. Even against the backdrop of a very large negative GDP gap, inflation is still high, with the expectation for 2017 being significantly above the 4.5% target. However, considering the damage that will occur if the Bank yields and undertakes more intense interventions, would it not be more advisable to loosen monetary policy sooner, as if its reaction curve gave greater weight to the GDP gap than to deviations of expected inflation from the target?

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