The frustrating economic activity and the Central Bank’s reaction function

BRAZIL ECONOMICS - Report 13 May 2019 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

Economic activity continues to disappoint, and based on the information available so far, it is perfectly possible that GDP contracted in the first quarter. This has prompted a wave of downward revisions in the growth projections for 2019, to the neighborhood of 1%. Another consequence is the inevitable increase in bets on a cut of the interest rate. Depending on the circumstances, we do not exclude the hypothesis of cuts later in the year. But we must point out that the Central Bank follows an inflation targeting regime, by which it sets the interest rate according to a reaction curve in which the variations of the SELIC rate (upward or downward) respond to the difference between the projected inflation (say 12 months ahead) and the inflation target. This is a type of “Taylor rule”, in which a differential of 1 percentage point between the two variables (upward or downward) leads, when the cycle of adjusting the interest rate is completed, to a variation (upward or downward) of more than 1 percentage point in the SELIC rate. Although the CB also considers the GDP gap, the strongest and most relevant influence on its response is the difference between projected inflation and the target. Hence, the decision whether or not to lower the interest rate depends on new inflation projections and expectations. If the decline of GDP growth winds up leading to a decrease of projected inflation below the target, we do not exclude the possibility of a cut, and this movement will be consistent if monetary policy counts on the proper backing from fiscal policy, as explained in the conclusion of this note.

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