In a recent interview, faithful to his newly acquired habit of throwing banana peels across the street and then crossing and slipping on them, President Lula criticized the current inflation target. In his words:
“Why does the Bank [Central] is independent and inflation, are interest rates the way they are? You set an inflation target of 3.7%, when you do that, you have to ‘tighten’ the economy more to reach that 3.7% [a meta em 2022, na verdade, foi de 3,5%]. Why did I need to do the 3.7%? Why not make 4.5% like we did?”
The idea that seems to guide the President’s proposal is not difficult to understand: it is about raising the inflation target so that, supposedly, the Central Bank can reduce the basic interest rate, enabling faster economic growth.
Ease of understanding, however, is not a criterion of truth (otherwise we could believe that the Moon is really made of cheese). In this case, it is a mistaken proposal, whose final effect will be the opposite of the desired one, that is, even higher real interest rates and less growth.
There is, in the presidential proposal, a crucial implicit assumption, namely, that – even in the face of a public announcement about a higher inflation target – people would not change their behavior, in particular with regard to setting prices and wages. . It’s hard to believe this kind of thing.
There are prices in the economy that remain fixed during certain periods. The best, but not the only, example is salary, which, once agreed, typically does not change for a year. Thus, when negotiating it, workers have to take into account not only inflation since the last readjustment and the objective conditions of the labor market (whether there is a lack or excess of vacancies, for example), but also, and crucially, which will be the inflation over the period in which the salary will remain unchanged.
If expected inflation is low, the provision against inflationary corrosion included in the salary will also be low; if it is high, the greater will be the readjustment today to offset the expected losses over the next 12 months. Put another way, expectations about the future behavior of inflation influence wages today.
In the same way, expected inflation affects – today – the set of prices in the economy: the higher it is, the greater the current increase in prices will be. (This contribution to macroeconomic theory and practice, by the way, helped Milton Friedman, Edmund Phelps and Robert Lucas win the Nobel Prize in Economics).
BC estimates suggest that an increase of one percentage point in expected inflation leads to an increase of about half a percentage point in current inflation, a far from modest impact.
Obviously, inflation expectations can be right or wrong. However, when it is the government itself, through a decision by the National Monetary Council (a body composed of the Minister of Finance, the Minister of Planning and Budget, as well as the president of the Central Bank), who indicates that the Central Bank should pursue a more high, it is more than reasonable to conclude that inflation expectations should rise.
This would already be complicated if the BC enjoyed great credibility, measured, for example, by the proximity between inflationary expectations and the inflation target. However, this is not what we observe. According to the most recent Focus survey, the expected inflation rates for 2023, 2024 and 2025 are, respectively, 5.5%, 3.9% and 3.6%, against targets of 3.25%, 3.0% and 3 .0% in the same years.
Other measures of expected inflation also point to values above the target, showing that, even with plenty of time for monetary policy to be implemented, the public does not trust the Central Bank’s ability to deliver inflation around the targets established by the CMN. In other words, expected inflation should also be above the new inflation targets.
This should lead, as argued, to the acceleration of inflation and, therefore, to the need for a reaction by the Central Bank, in line with its monetary policy rule.
Regardless of the precise format of the rule, all central banks historically able to keep inflation around the target have adopted the same principle: if inflation rises (or falls) by one percentage point, the interest rate must rise (or fall) more than than a percentage point.
Intuition about such a principle is less complicated than it seems. By raising the basic interest rate more than inflation, the Central Bank ensures that the real interest rate rises when inflation is higher, which leads to a slowdown of the economy and, consequently, inflation. Likewise, when inflation falls, the Central Bank reduces the real interest rate and induces more vigorous growth in activity and prices.
If this principle is not followed, any central bank will lose the ability to stabilize inflation.
Thus, in a scenario of accelerating inflation motivated by raising the target, the Copom would have to raise the real interest rate, under penalty of losing control, with a negative impact on growth and employment. As we warned, the opposite of what is thought to be the result of increasing the target.
Banana peel toss is a high-risk sport.
Alexandre Schwartsman was director of international affairs at the Central Bank and chief economist at ABN Amro and Santander. He is a founding partner of Schwartsman & Associados.
Alexandre Schwartsman