Monetary Policy Commitee reviews all the channels through which fiscal policy can harm the scenario of inflation convergence to the target

12/14/2022

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Central Bank’s building in Brasília — Foto: Jorge William/Agência O Globo

The Central Bank’s Monetary Policy Committee (Copom) is adopting a wait-and-see approach until it gets to know in greater detail the fiscal policy of the Lula administration. But it warned that an expansion driven by increased public spending could have the opposite effect to the one intended, slowing down the economy instead of stimulating it.

In the minutes of its last meeting, released Tuesday, the Copom reviews all the channels through which fiscal policy can block inflation from meeting the targets.

It can be because of aggregate demand, the rise in asset prices such as the dollar, the heightened economic uncertainty, the deterioration of inflation expectations, the increase in the neutral rate of interest or the loss of power of monetary policy if loans offered by state-owned banks gain ground.

However, the committee stopped short of giving a more concrete response to fiscal uncertainty – in other words, indicating an eventual postponement of the cycle of interest rate cuts or even a potential new hike in the key interest rate Selic.

Apparently, this environment of fiscal uncertainty had not worsened the Copom’s inflation projections. They rose only slightly, to 3.3% in mid-2024 from 3.2%, and remain compatible with the target on this horizon, which the Central Bank is currently aiming at.

In fact, despite all the fiscal uncertainty, the foreign exchange rate prior to the Copom meeting was flat at R$5.25 compared to the previous meeting, in October. Inflation expectations for 2024, until last week’s meeting, had not moved. The minutes say policymakers are a little concerned about the rise in the average inflation expectation, but what actually enters the inflation projection models is the median.

In theory, the Central Bank’s inflation projection can be influenced in case of revision of its estimate for the neutral rate of interest, which rose for the last time in June, to 4% from 3.5%, in real terms. But the minutes do not say whether there has been any revision. We may have more details on the subject on Thursday when the Inflation Report will be released.

Since the inflation projections have not changed, the fiscal policy could require an action from the Copom only from the balance of risks to inflation. But the way the Central Bank describes its balance of risks, there was no change. In other words, the balance between factors that can make inflation fall below expectations and those that can make it stay above has been maintained.

It seems there was no change because the Central Bank is adopting a cautious strategy in judging the fiscal policy of the future Lula administration.

“The current scenario, particularly uncertain on the fiscal side, requires serenity when evaluating risks,” the minutes say, repeating a phrase that already appeared in last week’s Copom statement.

Even so, the committee decided to send some messages to the future administration. The minutes reveal that the Copom did several exercises to check how fiscal policy can hinder the work of bringing inflation to the target. The idea implicit in these calculations is that, if it gets in the way, interest rates are likely to be higher, either because cuts will be delayed or further hikes in the key interest rate.

“The final effect, whether on inflation or on activity, will depend on both the combination and the magnitude of fiscal and parafiscal policies,” the Copom’s minutes say.

A relevant point mentioned by the policymakers is that the eventual fiscal and parafiscal stimulus planned by the future federal administration could have an opposite effect than expected, causing contraction instead of accelerating the economy.

The minutes cite two reasons for this. First, if the fiscal policy affects confidence in the sustainability of public debt. Another reason is linked to the degree of economic slack. With reduced slack, a significant fiscal expansion will hit inflation “and override the intended impacts on economic activity.”

This last point is sensitive, even to heterodox economists who support Modern Monetary Theory (MMT), which admits that there are limits to fiscal expansion when the economy is operating near full capacity.

But the controversy is not settled. The new administration has been claiming that, with the Transition PEC (proposal to amend the Constitution), it will keep spending stable in relation to GDP. But it has not shown any more detailed calculations supporting this thesis. The Central Bank makes more elaborate calculations about the fiscal stimulus, considering the structural primary balance.

What was missing was for the Central Bank to present its simulations to the public – that is, how much each fiscal dose affects inflation and activity. If the idea is to increase transparency, some detail may be included in the Inflation Report.

Otherwise, these simulations tend to remain under reserve for eight years, until the technical presentation made to the Copom is released.

*By Alex Ribeiro — São Paulo

Source: Valor International

https://valorinternational.globo.com/