Moment does not seem favorable to change inflation targeting regime – 05/17/2023 – Solange Srour

At the end of June, the CMN (National Monetary Council) will meet to define the 2026 inflation target.

After much speculation surrounding a possible raising of the 2024 and 2025 targets —which would most likely increase inflation expectations, making the expected drop in interest rates more difficult—, it is now conjectured, instead of flirting with this risk, to adopt a moving horizon for goal achievement.

An inflation target that is not linked to the calendar year is seen as natural, as most inflation targeting regimes have continuous targets. However, as with any change, there are risks that cannot be ignored.

Restricting the achievement of the target to the calendar year was a good option in 1999, when it was essential to build a system that would offer credibility after the fixed exchange rate was replaced as the monetary anchor.

The definition of a very well-delimited and easy-to-measure period helped in this objective, as well as the letters that the president of the BC began to write explaining the non-compliance with the goal, since they carry the symbolism of an “embarrassment” and expose the need to a monetary policy posture that brings inflation to the target.

In the international experience, the most common is to adopt a continuous long-term goal. This is how the European Central Bank, the Fed and the UK central bank, among others, operate. There are cases in which there is no tolerance interval, others in which there is no central objective (only one interval) and situations such as the Brazilian one in which there is a center and bands. In some cases, it is necessary to justify non-compliance with the goal. In others not.

I understand that the idea of ​​adopting a continuous target in the country would come with maintaining the intervals and the need to justify non-compliance in formal documents or pronouncements, which may occur on a quarterly, half-yearly or annual basis (based on inflation accumulated in 12 months).

What is the risk of such a change now? First, it is possible that there will be an increase in the range (currently 1.5 percentage points). This would be reasonable if justifications were presented more frequently, but there would be no reason for this if they were presented annually. Depending on the size of the new gap, we may have a feeling of leniency with the pursuit of the goal, which could affect expectations.

Second, if the frequency of justifications is greater than annual, they can be “trivialized”, and the “embarrassment” and the need for firmer monetary policy action disappear.

The third and perhaps most important point is the confusion that can occur between a change in the way of measuring compliance with the target and a change in the way of conducting monetary policy.

What is this mess? We know that monetary policy has an impact on the economy with long, variable and uncertain lags, usually estimated between one and two years. The horizon that the BC sees as appropriate for the return of inflation to the target and on which it guides its actions depends on these lags and the nature of the shocks that affect the economy (and their persistence), regardless of whether the return to the target is charged in the year -calendar.

In our experience of more than 20 years, when the BC was faced with shocks of great magnitude, it calibrated monetary policy in order to lengthen the time for convergence to the target, taking into account the costs of the adjustment process (in terms of output) associated with the existence of inflationary inertia.

The risk consists of the possible interpretation that, when adopting a continuous target, the BC should also target a more “extended” period of return for the target, regardless of the shocks and their impacts, considering that the target is long-term. The fact that the calendar year is abandoned as a measurement period could be confused with the abandonment of the commitment to act in time to bring inflation close to the target. Many may interpret that having a continuous target would make room for a drop in interest rates, which makes no sense.

The current moment does not seem to be one of the most favorable for us to introduce alterations in the targeting regime, not only because of the high pressure for an imminent drop in interest rates but also because inflation is far from the target, inflation expectations are unanchored and we have surpassed the top of the goal in the last two years.

It is natural for monetary policy to be managed with an eye to the future and to have the flexibility to accommodate shocks and uncertainties in its conduct. However, its administration is the responsibility of the BC.

It is important to make it clear that the CMN does not decide what is the appropriate horizon for calibrating monetary policy and, if there are changes in the tolerance intervals, it will be imperative to explain the reasons. Otherwise, as in the case of a change in the center of the target, disinflation will be more costly.

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