Economists evaluate improvement of the inflation targeting system – 02/26/2023 – Market

The inflation targeting regime will reach its 25th year in 2023 in Brazil, with a “success rate” of 70% and amidst the debate on a possible review of its parameters.

The Central Bank itself has studies to improve this system, as stated by the current president of the institution, Roberto Campos Neto, in a recent interview, in which he did not detail the possible changes.

Brazil is among the first ten countries that adopted the system that foresees the use of a basic interest rate, by a central bank, as the main tool to try to guarantee price stability and set inflation at a certain value.

Practically all relevant economies on the planet have an inflation target, which may be formal or not, defined by the government or by an autonomous body, to be achieved in the calendar year or in longer terms. The way of measuring price rises and the tolerance for some deviations also changes according to the country.

The issue also gained prominence with President Luiz Inácio Lula da Silva’s (PT) criticism of the conduct of monetary policy by the autonomous BC and with Minister Fernando Haddad’s (Finance) concerns with the high level of the basic rate (Selic) in Brazil, which started a discussion about the benefits of raising or lowering the current target.

One of those responsible for implementing the target system in Brazil in 1999, the chairman of the board at Jive Investments, Luiz Fernando Figueiredo, says that this system was the most modern at the time to replace the fixed exchange rate policy and became a trend in the following years.

He also assesses that the rule proved to be flexible to deal with inflation shocks over these years. According to Figueiredo, no central bank is currently trying, for example, to bring down inflation without evaluating the costs in terms of economic growth.

“Central banks, which increasingly use the targeting system, make a smoothing [da redução da inflação] due to economic activity. If you take it with fire and iron, it can generate a recession with little benefit in terms of inflation”, says Figueiredo.

“The other countries are, in practice, raising the inflation target, but without saying so. Is the Central Bank targeting 3.25% for this year and 3% for next year? It has to say yes, but it is with a flexibility, looking at what is happening in the world. What the world is doing is softening, thinking that this is more productive than changing the goal.”

José Luis Oreiro, professor of economics at the University of Brasília, assesses that the target regime in Brazil still follows very strict parameters. For him, there is no possibility, for example, of postponing the fulfillment of the objective in cases of shocks that are not of demand.

Oreiro considers it necessary to review the current target and says that the economic literature points to an optimal inflation rate of between 5% and 8% per year for developing countries. He also assesses that having an objective that will not be achieved for the third consecutive year does not seem to be the best way for the Central Bank to gain credibility.

“A target of 3.25% for Brazil is unrealistic. It will require a very big sacrifice in terms of high interest rates and damage to economic activity. We are seeing several companies with liquidity problems. The country is on the verge of a crisis large-scale financial situation,” he says.

This debate is not exclusive to Brazil. In the article “It’s time to revisit the 2% inflation target”, published in November last year, economist Olivier Blanchard (former IMF) states that inflation in the US should drop from the current 6.4% to something close to 3% this or next year.

From then on, there will be a debate on the costs of bringing it down to 2%, a target established by the Federal Reserve itself (American central bank) to be achieved in the “medium term”. Blanchard argues that the benefit of bringing inflation from 4% to 2% is small, given the costs in terms of reduced activity and employment.

Currently, advanced economies and some emerging economies have targets of 2%. In Latin America, the general target is 3%. In Brazil, the target was 4.5% from 2005 to 2018. It was gradually reduced in the following years. It is currently at 3.25%. It will be 3% from 2024.

Economists Bráulio Borges and Ricardo Barboza, from FGV (Fundação Getulio Vargas), published an article in which they claim that it is not clear that the 3% target is the most adequate for the current reality of the Brazilian economy.

They defend raising the target to 4% from 2024 onwards, noting that the value would still be lower than most of the time since 1999. They argue that average inflation in Brazil from 1999 to 2022 was 6.4% per year and that the average target for 59 developing countries was 4.5% last year.

They also cite a study by MCM Consultores which points out that the level of inflation from which Brazilian economic agents start to worry about the issue is 3.7%, closer to 4% than the 3% target already established for 2024 and 2025. Some studies calculate values ​​just above 3% for the US, something that fuels the debate there.

Since 1999, the target has been missed seven times. It was six years above or one year below the tolerance range. This should be repeated in 2023.

According to the Central Bank, the target system has been successful in Brazil and has enabled inflation to remain under control and at relatively low levels. “Fundamental to this has been the anchoring of inflation expectations, that is, people use the inflation target as a reference for prospective inflation. This gives greater predictability to the economy and improves planning by families, companies and the government”, says the institution.

Several central banks outside the country also defend maintaining the objective of bringing inflation back to the targets already established, despite the non-compliance in the most recent period.

In a paper on the subject, the IMF (International Monetary Fund) states that “inflation targets seem to have been more effective than alternative monetary policy structures”.

“Each country, however, must assess its economies to determine if the inflation target is appropriate for them or if it can be adapted to meet their needs”, says the Fund.

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How the inflation targeting system works in Brazil

1. The CMN (National Monetary Council), formed by the Ministers of Finance and Planning, plus the President of the Central Bank, sets the inflation target for a given year

2. To achieve this goal, the Copom (Monetary Policy Committee), a body formed by the president of the BC and its directors, has autonomy to define the level of the basic interest rate (Selic)

3. The BC carries out daily purchase and sale operations of public securities to keep the Selic close to the value defined by the Copom, which influences the funding cost of banks

4. The Selic rate affects inflation through various channels in the economy, such as credit, investments, consumption, expectations and the exchange rate

5. It is estimated that interest takes up to 18 months to reach its maximum effect on inflation

Characteristics

1. The target must be achieved in the calendar year (accumulated inflation from January to December)

2. The BC uses the inflation measured by the IPCA, the consumer price index measured by the IBGE, as a target

3. The goal has a tolerance interval, also defined by the CMN

4. The target can change every year. Since 2019, it has been reduced from 4.5% to 3%. It is set three and a half years in advance

5. If the IPCA is above or below the tolerance limits, the BC president needs to write a letter to explain the non-compliance with the target. This has already happened in 2001, 2002, 2003, 2015, 2017, 2021 and 2022.

Source: Central Bank of Brazil

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Inflation target in other countries

1. Long-term goal
The European Central Bank, the Federal Reserve (USA) and South Korea do not set a defined deadline for achieving their 2% targets, which have no tolerance range.

2. Inflation always on target
The central banks of Canada and the United Kingdom must always keep inflation within the tolerance range of 1% to 3%. The latter discloses more than one explanation per year, if this does not occur

3. Goal with interval and no central goal
In South Africa, inflation is expected to be between 3% and 6%, which leaves the central bank free to pursue any target within that range. In most countries, you should always aim for the center of the target, and tolerance serves to absorb deviations

4. Higher Goals
Some countries pursue targets higher than the 2% or 3% threshold. This is the case of Turkey (5%, with two points of tolerance). Brazil had a target of 4.5% most of the time

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