Messing with the inflation target would be suicidal, says Arminio Fraga – 06/27/2023 – Market

Economist Arminio Fraga, former president of the Central Bank, sees a possible change in inflation targets at the next meeting of the CMN (National Monetary Council), on Thursday (29), as “catastrophic” and argues that the target of 3 % becomes a permanent objective to be pursued by the monetary authority in an open horizon.

“Brazil is still moving towards the goal, despite having to make some sacrifices, it is quite impressive and should not be wasted. Since this effort has been made, in my view it is correct, changing the goal now would be suicidal”, he says to Sheet.

He says that the gains from replacing the calendar year (the current model, in which verification of whether the inflation target is met or not is done at the end of December) by a continuous target (with a moving term, disconnected from the closed year ) would be modest, meaning only an alignment with the conduct of monetary policy currently carried out by the BC.

Arminio evaluates that it would not be a great loss to extinguish the open letter that needs to be presented by the BC president when inflation ends the year outside the determined range. In the economist’s view, the monetary authority already reports on its performance several times throughout the year.

In your view, is the target of 3% from 2024 adequate? I’m really rooting for the National Monetary Council to maintain the 3% rate and declare that this is the target for an open horizon. For 2024, expectations in general, even the implicit inflation rate in Treasury bonds, have been converging [para a meta]. BC made it very clear that its horizons have already migrated to next year and may justify a perhaps slightly longer trajectory. [de convergência]. I see no reason to change anything.

Would a possible change in the tolerance interval also be negative? The function of the tolerance interval is not to allow a discretionary space not connected with the dynamics of the economy. The band is a way of signaling how much society tolerates deviation from the goal. What is behind this assertion is that the BC in the short term often has to deal with contradictory objectives. When the shock is one of supply, at the same time there is an increase in prices and a reduction in the level of activity [econômica]. In these situations, society must somehow signal its preferences, which is very subjective. If there is a narrowing or widening of the band, the signal being given is “we are willing to accept some inflation in the short term so as not to penalize the level of activity too much”. This happens due to the difficulties that the economy has in instantly adjusting, as there are already consolidated contracts and expectations.

Is the perception of President Lula and members of the government wrong when they talk about changing the inflation target to reduce interest rates? It is an illusion, because even in the short term it is not possible to achieve this. Expectations have been tamed with great difficulty, largely due to the fragility of public accounts. In this recent period, there have also been relevant supply shocks, such as the pandemic and the fight between the United States and China. The resulting repositioning of production chains around the world puts pressure on costs. And there’s the demand side as well. I think that from then on the BC has to do its calculations and act. For next year, expectations are converging, but the policy should remain restrictive for a long time.

I think it would be catastrophic to change the target, as it would bring enormous uncertainty, it would be a very bad signal. The government has already given a positive signal, albeit preliminary, in the fiscal area. Everything indicates that this framework will be approved. I hope this is just the beginning of an adjustment, which, then, will give the BC a lot of room to work and who knows how to return to what we had during the golden moments of the ceiling, with real interest rates at the long end of the curve already below 4% . It would be extraordinary for the country, but it requires courage and cold blood. Another shot in the foot would be to expand loans from public banks too much, as has been done in the past.

What other harms, in addition to increased uncertainty, would changing the target bring? Maintaining the goal would be a relevant achievement for a country with our history. Especially in a period in which fiscal responsibility was abandoned, first with the Fiscal Responsibility Law itself being repeatedly disrespected, and then with the demoralization of the ceiling. Brazil still moving towards the goal, despite some sacrifice, is quite impressive and should not be missed. Since this effort has been made, in my opinion it is correct, changing the goal now would be suicidal.

The discussion about replacing the calendar year with the continuous goal gained strength. Would this be, in your view, a consolidation of the practice already adopted by the BC today? What would be the gains? Gains would be modest. The biggest gain would come from establishing the 3% as a permanent target. That would be the big advantage. The question of annual inflation, in practice, never had much importance. There is no Central Bank that will throw interest rates skyward in the second half of the year to try to reach the target in the same year. Since we started, the annual target had two objectives, the first was to signal a downward trend, which worked quite well in the beginning. Then, road accidents happened. But as a system, I’d say it worked. Brazil has gone through numerous stress tests, but the system has survived. Since these procedures have been consolidated, with small variations from each administration, it has become increasingly clear that the BC operates with the concept of horizon of monetary policy action. Today, for example, the BC is already signaling that it is looking to the end of next year.

So, the calendar year simply triggers the BC president’s letter to the finance minister rendering accounts. I have nothing against the letter, but I also don’t think it is so essential as the BC reports to each Copom in great detail, then four times a year an even more detailed inflation report comes out, with studies, and there is also the obligatory presence of the BC president in Congress. I wouldn’t mess with the letter, but the idea of ​​frequent letters doesn’t make sense.

Regarding the deadline for verifying the achievement of the target, what do you do you consider ideal? Would it be, for example, following the monetary policy lag period? What the BC can do through its actions [com a ferramenta taxa de juros] is to contract demand and thus have some impact on expectations. Specifically, that’s it. The BC needs to identify whether it is facing supply or demand issues, whether they are temporary or permanent and what their dimension is. This exercise is not trivial at all. BC will not treat the various permutations in the same way. If it is a negative demand shock, the BC simply tries to compensate for the shock by reducing interest rates to increase demand and vice versa.

When the issue moves to the supply side, the matter becomes more complicated. The more or less accepted doctrine today is that the impact of the supply shock on prices must be accommodated, but its knock-on effects must not. As the BC is not sure what kind of shock it is, it should not fully accommodate the impact of the shock—either up or down. But it must, yes, accommodate in part and ensure that inflation expectations remain anchored. In other words, in jargon, the Central Bank softens the impact of the shock and, therefore, the fluctuations in activity.

There is nothing that says that BC has to wait 18 months [tempo estimado para que a política monetária atinja seus efeitos na economia]. It is true that the impact of monetary policy is quick, but it is not full, a period that no one knows for sure. It is used for 18 months, but it can be different. I think this deadline has been shrinking given the increasing speed of reaction of expectations, of the financial markets, and also of the goods and services markets. There is sometimes a misperception that you should always work with 18 to 24 months. Depending on the necessary adjustment, it may be more or less time. That is, it is not a license to procrastinate.

Should the CMN determine this verification period or leave the definition to the BC? It should be left to the BC, which already has this concern. BC has to be careful and not promise more than it can. The BC will not make the economy grow faster. It may even recover faster, but growing sustainably depends on more investment, more productivity, more technology, more ideas, tax reform, state reform, a revolution in education, public health, sanitation. Brazil has a huge space to grow, totally underused.

If the model of the cards is maintained, depending on what is drawn, can the excessive use of the instrument lead to a trivialization? It would be one more ingredient [da prestação de contas], but the fact is that BC has a very formal system, very tidy, very transparent. Doing away with the letter would not be a great loss.

Mr. Do you advocate that there be a review of the inflation targeting model from time to time? I see no reason. Maybe some technical tweak.

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ARMINIO FRAGA, 65

Economist from PUC-Rio (Pontifical Catholic University of Rio de Janeiro) and PhD in the area from Princeton University, he is a founding partner of the management company Gávea Investimentos. He was managing director of Soros Fund Management, the investment company of businessman George Soros (1993 to 1999), and president of the Central Bank of Brazil (1999 to 2002). He founded and chairs the boards of Ieps (Institute of Studies for Health Policies) and IMDS (Institute for Mobility and Social Development).