Do interest rates in Brazil really have to fall? – 03/08/2023 – Solange Srour

Soon we will know what is the proposal for the new fiscal framework that will replace the spending ceiling.

There is great expectation on the part of the economic team and the government that such an announcement —together with the re-enforcement of taxes on gasoline and ethanol and other measures focused on reducing the expected deficit for this year— will finally open space for the Central Bank to start the long-awaited interest rate reduction process. Will these initiatives be enough to assure the monetary authority that it has considerably reduced the risk of inflation being above the target?

There are two main transmission channels of fiscal policy for inflation.

The first is via aggregate demand: higher government spending or lower taxation boost consumption and private investment. GDP growth puts pressure on the economy’s productive capacity, which can lead to higher inflation. When fiscal policy is contractionary, the opposite occurs.

The second is the channel of expectations for the trajectory of the public debt: a fiscal policy seen as unsustainable over time (followed by structural primary deficits) results in acceleration of inflation. This is because when it becomes difficult to envisage fiscal sustainability, investors demand higher interest rates to finance fiscal deficits, aggravating the problem.

In general, as a consequence of the increase in the risk premium, there is an exchange rate depreciation and an increase in inflation expectations. In some cases, investors come to expect that the government will choose to improve fiscal indicators by increasing inflation (inflationary tax) or that the Central Bank will give up controlling inflation in order not to worsen the debt dynamics —both situations have an impact on inflation expectations.

Inflation expectations are one of the main variables used by the Central Bank, as they are incorporated directly into the prices of products, services and wages. In addition, they are essential for estimating real interest rates, which impact consumption and investment decisions and, therefore, the level of activity and inflation.

Undoubtedly, the recent measures that increase tax collection help to reduce this year’s expansionist fiscal impulse, however they do little to reduce the uncertainty regarding the dynamics of the debt in the years ahead. This is the importance of the new fiscal framework: bringing greater predictability and confidence about future primary surpluses, reducing inflation expectations that began to lose anchor with the approval of the Transition PEC.

There is no point in preaching that the new framework will be transparent, flexible and sustainable. For the Central Bank to cut interest rates, it will be necessary for inflation expectations to react to these qualities.

It is not just fiscal policy that will define monetary policy — other variables are important in determining inflation. One in particular has changed a lot since the end of last year: the global landscape. The consensus that the monetary policy normalization process in advanced countries is nearing its end is no longer valid. After the recent inflationary surprises in the US and Europe, there are many questions about how far central banks in these regions will go with interest rates and how long they will need to stay in restrictive levels.

Higher global interest rates require more caution in the conduct of our monetary policy.

Another relevant variable for the beginning of the interest rate reduction process is the evolution of credit. The significant tightening of financial conditions and its impacts both on bank credit concessions and on companies’ access to the capital market are about to trigger the return of subsidies with a possible change in the TLP law (approved in 2017).

As it is difficult to separate the problem of contagion in the credit market from the stage of the credit cycle, the path to be chosen seems to be to cushion the restrictive effect of the Selic and market rates. When the monetary policy finally starts working, we run the risk that, instead of discussing structural improvements in the credit market, we will weaken its transmission channel.

We are at the beginning of a fiscal framework reconstruction process that requires credibility in a more challenging external environment. If we go in the right direction with aligned policies, the Central Bank will be able to efficiently carry out the task of keeping inflation around the target, creating conditions for the Brazilian economy to resume growth. Otherwise, we run the risk of repeating the route of the deep recession between 2014 and 2016.

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