Monetary Policy Without a Fiscal Anchor

BRAZIL ECONOMICS - Report 03 Aug 2022 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

The Central Bank’s formal independence was incontestably a great achievement. But this is only a necessary condition to control inflation. The high risk premiums due to the government’s failure to satisfy the intertemporal budget constraint will lead to unsustainable interest rates and high inflation, with the risk of fiscal dominance. This proposition has reverberated among economists of virtually all currents of thought. Here we chime in on the subject, by analyzing some pertinent examples.

We start by showing that the current flat yield curve at a yearly rate higher than 13% is due to the high fiscal risk premium. This is the case despite the current primary surplus. In 2021 and so far in 2022, the instantaneous budget constraint has been satisfied, but not the intertemporal budget constraint, which is what matters for evaluation of fiscal risk.

Initially, we describe what has been happening with the slope of the yield curve and the quotations of Brazil’s CDS, and compare their behavior with that in two other episodes. The first was in 2015, when the government blithely ignored fiscal discipline and generated deficits that caused Brazil to lose its investment grade rating. The second was in 2016, when enactment of the spending cap enabled the Central Bank to bring inflation down to the target. In the first case, the yield curve’s slope remained steeply positive, and in the second, the curve was negative. In the first case, Brazil’s CDS quotations for 5 years grew more than the median of 10 representative countries, and in the second it was near that of those other countries. fiscal fundamentals.

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