The costs of discussing the target – 7/3/2023 – Cecilia Machado

The CMN (National Monetary Council) meeting last week brought three decisions related to the inflation targeting regime. First, it changed the assessment of goal achievement to a continuous period. Second, it set the 2026 target at 3%. And, third, he reiterated that the target for 2024 and 2025 —which had been defined in past meetings— remains at 3%.

Of the three, only the first represents a change in the targets regime, since, in the current design, it is up to the CMN to define the objectives that will be pursued well in advance —three calendar years ahead— and to commit to the previously defined targets.

Under the new calculation rule, inflation must be continuously within the tolerance range, not just at the end of each calendar year. As the effects of interest rates on the economy are lagged, and there are many other factors —such as rising commodity prices or bottlenecks in global production chains— that change the inflation observed at a given point in time, continuous assessment makes the goals more efficiently. It makes it possible to smooth the process of inflation convergence from the incidence of the shock, considering that it takes time to dissipate.

Even if it is a right decision, the practical effects should be small. The previous rule already contemplated the possibility of non-compliance with the target in the calendar year for the above reason. When this happens, the Central Bank provides clarifications in an open letter, as was recently done for the years 2021 and 2022. Thus, the continuous target only reinforces the understanding that noncompliance with the target at a certain point in time does not mean deviations of action of the Central Bank in relation to its mandate, as it is currently understood.

Surprisingly, the most anticipated announcement of the meeting was the definition of the center of the goal, which was contaminated by political discussions in favor of its elevation. Despite the fact that the target was finally confirmed (and maintained) at 3%, all the discussion about raising it brought real damage to the economy.

Uncertainties regarding the new target were reflected in inflation expectations over longer horizons, which began to incorporate the risk that a change could actually happen. Inflation expectations are an important transmission channel for monetary policy and act as an anchor, guiding price and wage adjustments that take place in the economy.

Off-target (ie, unanchored) expectations make the disinflationary process much slower and more costly, as future inflation estimates feed current inflation. When expectations are unanchored, monetary policy needs to act more forcefully to bring inflation to the established target.

Throughout the year, inflation expectations (median) for 2025, 2026 and 2027 reached 4%. Of course, the process of unanchoring expectations may have other causes —since it also incorporates uncertainties regarding the fiscal path or even questions about the monetary authority’s leniency with inflation—, but the significant improvement in forecasts after the confirmation of the target at 3% last week. This week, the median inflation expectation for 2025 fell from 3.79% to 3.6%, while that of 2026 fell from 3.7% to 3.5%.

Everything indicates that we are starting to see a process of re-anchoring expectations that comes mainly from the correction of directions in the discussion of the goal. Doubts about the inflation trajectory take away all the advantage that the target system brings to the economy, increasing uncertainties and harming the ability of families and companies to plan for their future.

The simple discussion about changing the target raised inflation expectations, harmed the deflationary process and postponed the start of the cycle of interest rate cuts, contrary to what was intended. It implied a more significant deceleration in the granting of credit, a more pronounced increase in defaults and a less dynamic labor market. All this could have been avoided if the political debate respected the technical knowledge produced on this subject a little more.

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