Lula’s risky bet on the Central Bank – 03/27/2023 – Why? Economês in good Portuguese

The decisions of the Central Bank, as well as those of any government body, can always be criticized. There is room for debate about the value of the Selic rate stipulated by the institution. However, the Executive is doing this in a counterproductive way, putting heavy pressure on the institution. The discussion does not take place in technical terms and often appeals to the personal side – for example, focusing on potential ulterior motives of the president of the Central Bank, without any factual basis for this.

The rationale behind the Central Bank’s autonomy is to shield the institution from political pressures. There is always the scenario in which the Executive will subjugate the Central Bank, using monetary policy to close the hole in the public accounts, which leads to high inflation. This scenario is not a theoretical fiction of economists. Our recent past of hyperinflation (which lasted until the mid-1990s) shows exactly this mechanism at work. Currently, our neighbor Argentina, whose 12-month inflation has just reached triple digits, is experiencing this drama.

With autonomy, the President of the Republic cannot dismiss the directors of the Central Bank. He needs to wait for the mandates to end to appoint successors. And the mandates of directors do not coincide with that of the head of state. This, in theory, reduces the Executive’s potential to interfere in the course of monetary policy. The bad scenario of high inflation becomes less likely, reducing inflation expectations.

It is important to point out that, by autonomy, it is understood that the Central Bank chooses the instruments to keep inflation as close as possible to the target. But the institution does not determine the inflation target – it is the National Monetary Council, made up of the president of the Central Bank and the ministers of Finance and Planning.

Controlling expectations is crucial to controlling inflation itself. That’s because many prices in the economy are sticky, that is, they only change from time to time. Those who are readjusting the price today do not want it to be too outdated (neither too high nor too low) during the time it will remain stationary. As it is not known what inflation will be in the future, many readjustments are made based on expectations.

If inflation expectations are high, readjustments today will be more aggressive, which contributes to boosting inflation in the present. The Central Bank’s autonomy, by keeping expectations anchored, helps to rein in this process.

However, autonomy on paper is not a sufficient condition. The Central Bank must be perceived as a de facto autonomous institution, whose main objective is to keep inflation under control. That is why the Executive’s strategy of putting pressure on the Central Bank is extremely risky. When the Central Bank finally lowers the Selic rate, will this be interpreted as a technical decision or will it look like it has finally given in to President Lula’s pressure?

If the public’s interpretation leans towards the second case, the Central Bank’s perception of autonomy falls to the ground (even with autonomy on paper). It is an invitation for expectations to be unanchored. In this situation, controlling inflation would become an even more difficult and costly task.

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