The Central Bank’s Policy and the Growth of the Neutral Interest Rate

BRAZIL ECONOMICS - Report 08 Aug 2022 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

At the last COPOM meeting, the Central Bank raised the Selic rate to 13.75% a year and did not rule out one or more new increases of lesser magnitude. Even though it is widely recognized that monetary policy is already strongly restrictive, which will lead to a decline of inflation, criticisms exist that the risks are so great that the Central Bank should be more aggressive in future elevations.

Our purpose in this report is to discuss this controversy, and unusually (since we generally are critical of the Central Bank’s policy decisions) explain why we agree with its recent decisions. In a previous report (“Monetary Policy without a Fiscal Anchor”), we described the effects of the “fiscal unanchoring” on the yield curve and CDS quotations. Here we present evidence that the trajectory (clearly upward) of the yields of the NTN-Bs provides a good estimate of the growth of the neutral real interest rate in Brazil. In light of this growth, two questions arise. The first one is: might a mistaken calibration of the neutral interest rate hamper (or even prevent) the Central Bank from meeting the target?

After all, in our estimate, the neutral real interest rate is already above the “consensus” level, of 4%. The second one is: How long can the Central Bank avoid the growth of the neutral interest rate - a consequence of the expansionary fiscal policy - from leading to fiscal dominance? In response to the first question, after a summary of the theory on the topic, we show that even without knowledge of the true neutral rate, the Central Bank will attain the target at a relatively low cost if it follows a Taylor rule in which it adjusts the interest rate in response to the difference between the expected inflation rate and the target. In other words, it will be rising the policy rate until the expectations are anchored to the inflation target. With regard to the second question, however, if the government does not construct a framework that assures satisfaction of the intertemporal budget constraint, the risk premiums will increase, closing a vicious circle of rising inflation and interest rates (neutral and market). For the time being, that fiscal framework is not in sight, exposing the Central Bank to the risk of fiscal dominance.

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