The Full Adjustment of the Interest Rate: In Search of the Inflation Target
At the next COPOM meeting (June 16), not only will the SELIC rate be increased by 75 basis points, there will also be announcement that the commitment is no longer to a partial adjustment, but rather to the adjustment necessary to bring inflation back to the target. This movement was already anticipated by the market (as shown by the increased slope of the short end of the yield curve and the number of institutions predicting the SELIC rate will be over 6% at the end of this year).
This is necessary because: a) unless a water crisis leads to energy rationing, the economy will grow this year near (or slightly above) 5%; and b) inflation is still far from indicating a cooling trend. In this report, we show that if the Central Bank continued to worry about slowly removing the monetary stimulus to economic activity, it would run the risk of unanchoring expectations.
Should the market perceive that for an extended period there is an excess concern over maintaining the monetary stimulus in relation to the goal of meeting the target, this would be interpreted as if the Central Bank had an implicit inflation target higher than the official one. Through application of a Kalman filter, we show that to some extent this has already been happening.
Since there are no longer any reasons for concern over economic recovery (which is strong), and since the Central Bank knows full well the disastrous outcome of pursuing a higher implicit target starting 2011, there are no reasons to believe it will not explicitly announce the objective of meeting the target with an integral adjustment (in the sense of one compatible with the neutral interest rate).
INFLATION TARGET AND IMPLICIT TARGET – To calibrate the intensity of altering the basic interest rate, central banks try to minimize a loss function, involving two costs: the deviations of inflation (current and expected) in relation the target; and the gap between actual GDP and potential GDP. If the monetary authorities ignore the cost emanating from the GDP gap, they will seek rapid convergence to the target, influencing expectations, which (endogenously) will tend to the target, accentuating their effect on inflation. But if they assign excessive weight to the GDP gap, they will react less to the increase of inflation, giving the impression they have an implicit target higher than the official one.
We start from a small model similar to that of the Central Bank, in which we use its own estimates of the GDP gap and the neutral real interest rate (of 3%), and through a Kalman filter we extract the implicit inflation target for the entire period of the inflation targeting regime. Between 2011 and 2014, the Central Bank de facto worked with an implicit target equal to or higher than the upper limit of the interval containing the official target, and the results are known: expectations one year ahead became unanchored, and actual inflation grew steadily, in 2015 climbing above the top of the target interval.
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