The Mistake of Raising the Inflation Target

BRAZIL ECONOMICS - Report 23 Jan 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

The necessary condition to achieve the goals of accelerating economic growth and improving the distribution of income is to enact micro and macroeconomic reforms. But this is only one condition, which depends on Congress. The other, which depends exclusively on the Central Bank and the fiscal authority, is to keep the real interest rate low to stimulate private investments. The interest rate set by the Central Bank (kept at the desired level through open market transactions) is the nominal rate, not the real rate.

The real rate is the nominal rate minus the expected inflation rate for one year ahead, whose value is tied to the inflation target. For this reason, Brazil’s Central Bank (like other central banks) pursues a monetary policy able to keep inflation expectations anchored to an inflation target that is immutable over the relevant monetary policy horizon. At present, Brazil is experiencing a fiscal-monetary conflict, with monetary policy firmly in restrictive territory while fiscal policy remains expansionary. The former policy reduces inflation while the latter increases it. The correct way to resolve that conflict is to start by reducing the primary deficit in 2023 and establishing a fiscal framework that supports monetary policy.

Unfortunately, with a populist bent, President Lula has misguidedly directed his ire against the Central Bank’s independence and professed the need to raise the inflation target. He believes that by lowering the nominal interest rate, the real rate will decline as well. If the government follows this path, the outcome will be higher inflation along with a higher real interest rate, accompanied be weaker economic growth. The objective of this report is to demonstrate the consequences of this error.

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