World’s largest rate hike casts doubt on Central Bank’s power to fight inflation

Inflation, hyperinflation and deflation? | Tendercapital

Brazil was the country that raised interest rates the most in 2021 and yet boasts one of the highest consumer inflation expectations for this year when compared to its peers. For some analysts, the figures show that inflation in Brazil has reacted little to increases in the Selic policy interest rate. This theory diverges from what members of the Central Bank’s Monetary Policy Committee (Copom) and other economists argue. They say monetary policy has gained “power” in recent years, as inflation is reacting more than before to changes in the basic interest rate. The discussion may gain substance among economists in 2022, in an environment of still pressured inflation and a presidential election.

A survey by Emilio Chernavsky, doctor of Economics from the University of São Paulo, shows, for example, that the variation in interest rates in Brazil was much larger than in other countries. According to data from the Bank for International Settlements, the 7.25 percentage points hike in the Selic last year puts Brazil firmly in the lead of the ranking of countries with the biggest increases in the basic interest rate. In second place comes Russia, with 3.25 points. In the case of consumer inflation expectations for this year, Brazil has the fifth highest estimate, of 4%, behind Turkey (14.5%), India (4.9%), South Africa (4.5%) and Russia (4.3%), according to the International Monetary Fund.

“Monetary policy is very little effective in Brazil,” Mr. Chernavsky said. “We were by far the country that raised the basic interest rate the most, and this did not lead us to comfortable inflation, despite the fact that our economy is already stagnant,” he added, pointing out that the cycle of hikes has not yet ended. The median projection of Focus, Central Bank’s weekly survey with economists, for the basic interest rate, currently at 9.25% a year, is 11.75% by the end of 2022.

The economist cites some reasons why he considers that monetary policy is not very effective in Brazil. One is the fact that commodities and regulated prices have a large weight in the Extended Consumer Price Index (IPCA), Brazil’s official inflation. In practice, this means that changes in the basic interest rate affect only 70% of the IPCA, according to him. Another reason is the high volatility of the real, which in many cases generates a “precautionary cost pass-through.”

He also highlights the role of “systematically large” spreads in Brazil, or the difference between the rates charged for loans and for raising funds. Mr. Chernavsky cited credit cards as an example, “one of the main ways of financing consumer spending” in the country.

“In the case of a 7-percentage point increase in the Selic, even if this is passed on in full, the final rate will rise, say, to 307% per year from 300%,” he said. “The impact on the loan installment will be negligible.”

On the other hand, increases in the Selic rate of the same magnitude increase costs for companies by putting greater pressure on the cost of working capital lines of credit, whose annual rates “are at 20%, 30%.”

“So the thing is: the credit channel works very badly,” he said. “Selic hikes hardly impact demand, but increase costs for companies. So the net effect on inflation ends up being small.”

Given these distortions, Mr. Chernavsky is in favor of using other instruments besides the basic interest rate to keep inflation in check. Among them are reserve requirements (collected by the Central Bank through rates levied on funds raised by financial firms), a Tax on Financial Transactions (IOF) and a “fiscal fund” to help give more stability to fuel prices.

The Central Bank has been defending the thesis of increased monetary policy power since 2019. In its quarterly inflation report for the first quarter of 2020, the monetary authority discussed the reasons why it considered that the power of the interest rate had increased. More recently, at the end of last year, the then director of economic policy, Fabio Kanczuk, reinforced this idea, citing the approval of the Long-Term Rate (TLP) in 2017 and the reduced role of the Brazilian Development Bank (BNDES) as reasons why inflation is reacting more to Selic hikes.

For Zeina Latif, an economic adviser at Gibraltar, it is not possible to say that the cycle of basic rate hikes last year and the inflation projections for this year show a loss of power of monetary policy.

“Any way to measure this now would be very limited because of natural lags in monetary policy,” she said. In the current cycle, the Central Bank first raised the basic interest rate in March last year, to 2.75% a year from 2%.

“We are now starting to feel some first signs of the hikes on economic activity,” she said. “Only then come the impacts on inflation. Definitely, there wasn’t time yet to feel the impacts on inflation.”

Ms. Latif says that monetary policy has gained power since the Rousseff administration, but believes that part of this gain was reversed in the last two years, when a “fiscal deterioration” began. The strongest sign, according to her, are the higher projections for the neutral interest rate, the one that neither accelerates nor decelerates inflation. In December, the Central Bank itself raised its estimate for the annual neutral interest rate in real terms, to 3.6% from 3%.

“If monetary policy is underpowered, the interest rate has to be higher. To stabilize inflation, you need to make a greater effort, so the neutral interest rate is higher,” she said. “Fiscal deterioration puts a burden on interest rates. There is no way. Monetary policy and fiscal policy are communicating vessels.”

Carlos Kawall, director at Asa Investments, says that “monetary policy clearly gained potency when there was the change of the parafiscal regime [linked to BNDES and subsidized interest rates] and the implementation of TLP.”

“Today it doesn’t seem that we have an ineffective monetary policy,” he said.

According to him, inflation in Brazil is “higher than the global average, but not as high as it was in the past.” The path of prices “higher and more resistant to decline” is a common factor to emerging countries, compounded in Brazil by the “inertial component,” which is how much past inflation affects current inflation. For Mr. Kawall, using the comparison between the cycle of interest rate hikes and inflation projections to say that monetary policy has little power is to “criticize the medicine instead of look at the disease itself.”

Source: Valor international