Fiscal Risk, Exchange Rate and Inflation
Inflation measured by the IPCA-15 has accelerated sharply in recent months, rising from 1.9% in June to 3.5% in October over the preceding 12 months. This increase has a visible “cause”, namely the weakening of the exchange rate, and if that were all, we could conclude that: a) the increase of inflation has been triggered “solely” by a “shock” – the exchange rate depreciation; and b) if expectations remain anchored, the consequence will only be a change of relative prices. However, the problem is much more complex. First, the weakening exchange rate is largely due to the degree of insolvency of the government, which will only be reversed with a return to fiscal austerity based on economic policy actions, not mere promises. Second, although the latest version of the Central Bank’s Focus survey does not yet provide evidence of unanchoring of expectations, there are clear signs of an increase of expectations reflected in public bond yields and the increasing positive slope of the short end (from zero to one year) of the yield curve. Although in the short run, there are no reasons for the Central Bank to alter its smoke signals, reasons abound for it to continue warning that keeping the interest rate low depends crucially on solid measures to assure compliance with the spending cap in 2021 and beyond. Unless the credibility of efforts to correct the fiscal problem grows, it’s likely that in a few months a new monetary tightening cycle will start, and the debate will only involve its intensity.
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