Supply Shocks and Monetary Policy

BRAZIL ECONOMICS - Report 21 Mar 2022 by Affonso Pastore, Cristina Pinotti and Paula Magalhães

In response to the two shocks caused by the Russia-Ukraine war – oil prices and food prices – the Central Bank raised the SELIC rate by one percentage point at the last COPOM meeting, and announced that a new increase of the same magnitude is impending at the next meeting, which would put the rate at 12.75% a year. But nothing guarantees this will be the end of the tightening cycle.

There are still risks both external (war and higher interest rates in the USA) and internal (stronger fiscal impulses in an election year), both of which might oblige the Central Bank to extend the upward cycle. When the decision on the increase of 100 basis points was reached at the last meeting, the SELIC rate was already in strongly restrictive territory. The interest rate relevant to affect the behavior of aggregate demand is the one-year ex-ante real rate (the DI for 360 days deflated by inflation expected one year ahead), which in the months preceding the last COPOM meeting was approaching 7%.

This already was sufficient to cause a sharp deceleration of the economy. Due to the contraction of aggregate demand, inflation will certainly decline, but possibly at the cost of a recession starting toward the end of 2022 and extending through much of 2023. The inflation picture will tend to be aggravated by fiscal easing due to the coming elections.

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