Success of Banco Central in Managing the Rate of Inflation - Essay Example

(Word count: 2653) Success of Banco Central in managing the rate of inflation The implementation of floating exchange rate regime and of the inflation targeting regime in Brazil at a critical moment for the Brazilian economy in 1999 is a hallmark in the history of Central banks in emerging economies. The inflation target regime was formally instituted in Brazil through a decree 3088 of June 21, 1999. The significant improvement in transparency and credibility that has taken place over the past three years has been incorporated into the working structure of the Brazilian Central Bank (Banco Central, 2003). Brazil faced a financial crisis in 1999, both fiscal and balance of payment weaknesses, which was the spill-over effect from the previous year. In mid 1998, Brazil's consolidated fiscal position was showing primary deficit, as the government expenditure exceeded its income. The current account deficit was approaching 5% of GDP, even as the economy was sliding into recession. The situation was further aggravated when Russia defaulted on its debt payment and external capital flow came to a halt (Fraga, 2000). Floating of Real was the course of action taken by the government in January 1999 with the consequence that the exchange value of Real plunge to an all time low R$2.15. The government realised that any drastic step taken out of distress rather than alleviating the problem could create further imbalances by fuelling inflation. The government was contemplating whether to float, peg and initiate a fixed- rate regime. After looking through all the possibilities the government had announced in March 1999 that the full inflation targeting system would come into force in June 1999. The Brazilian government could have taken recourse to many instruments at its disposal to implement country's economic policy but the government had assigned to the Central Bank the task of keeping the rate of inflation at a low level. The option proven to be more efficient by the government to conduct monetary policy is the inflation targeting regime because it works on specific targets for the monetary authority. This regime brings transparency to the targets being pursued and allows for reporting to society the absolute commitment to the control of inflation. Another reason for choosing the inflation targeting regime is its' near immunity to political influence in policy decisions. Another purpose of the regime is to coordinate the prospects of inflation. While this contributes towards achieving the target, at the same time, it may enhance the credibility and transparency. The inflation targeting regime helps to buffer the shocks hitting the economy. Due to the flexibility of the system, it can absorb these shocks. Brazil is a country that is still dependent on foreign capital. Introduction of floating exchange rate as a part of the inflation targeting regime will directly absorb part of external shocks. The key points of the inflation targeted regime can be summarized as follows: Inflation target will be established on the basis of variations of a widely known price index The inflation targets as well as the tolerance intervals will be set by the National Monetary Council on a basis of a proposal by the Finance Minister The price index that would be adopted for the purpose of inflation targeting framework will be chosen by the National Monetary Council on the basis of a proposal by the Finance Minister The targets will be considered to have been met whenever the observed accumulated inflation during the period of January-December of each year falls within the tolerance interval In case the targets are breached, the Central bank's Governor needs to issue an open letter addressed to the Finance Minister explaining the causes of the breach, the measures to be adopted to ensure that the inflation returns to the tolerance levels, and the period of time that will be needed for these measures to have effect, and Central Bank will provide a quarterly inflation report. The National Monetary Council (CMN) set inflation targets of 8.0%, 6.0% and 4% for the IPCA variation for the years 1999, 2000, and 2001. In the first two years of the program, the target was achieved with inflation, as measured by the IPCA, reaching 8.9% and 6.0% in 1999 and 2000. In 2001, the inflation was above the established target, which reached 7.7% (above 6% upper limit of inflation target set for that year). In 2001, the Central Bank acted in a preemptive manner aiming at reducing the potential inflationary effects of the depreciation of the exchange rate and increase in the prices administered by contracts, especially in order to avoid the propagation of the shocks. If the Central Bank had not acted in such preemptive fashion, the inflation would have been higher than the observed. The set of shocks that hit the Brazalian economy in 2001 generated trends for the exchange rate and prices administered by contracts different from the ones projected at the end of 2000. This unexpected trend in exchange rate as perceived by the Central Bank may be attributed to a perception of a worsening profile of Brazil's balance of payments. The deepening of the Argentine crisis and the anticipation of a more intense showdown impacted the exchange rate which necessitated higher adjustment in Brazil's external accounts. Additional pressure in the exchange rate was exerted by the energy crisis. Consequent upon the 9/11 attack in the United States, along with the world economy, exchange rate plummeted downward in Brazil. By the end of the year 2001, much of the depreciation was reversed (down to about 20%) but the inflation target had already been irremediably compromised. Inflation was 7.7% in 2001, almost twice the central target of 4% and outside the 2% tolerance margin. The central bank estimated that inflation would have been 4.8% in the absence of exchange rate depreciation, and even closer to target if it had not been for the 18% increase in electricity rates (Bevilaqua and Loyo, 2005). The Central responded by complementing the interest rate policy by increasing the reserve requirement ratio on time deposits. The bank also intervened temporarily in the exchange rate market with a favorable outcome. The Central Bank finally managed to restrain the spread of the shocks by mid 2001, as was observed by Central Bank of Brazil's Monetary Policy Committee (Copom) and the celic rate was stable at 19% p.y. throughout the second half of 2001. The economic policy measures in 2001 were implemented taking into account the magnitude and effects of the shocks that hit the Brazilian economy. The year 2002 was characterized by confidence crisis in the performance in the Brazilian economy and an increase in risk aversion in the international market. Demand for public securities declined significantly in the domestic financial market and the decrease in foreign fund was also considerable. Net foreign direct investment flows which had reached US$22.5 billion in 2001, decreased to US$16.6 billion in 2002. Gross private financing totaled US$4.4 billion in 2002, in comparison to US$12.4 billion in 2001, leading to a decline in the average rollover rate to 33% from 98%. The higher risk perception inhibited aggregate investment, which dropped to 18.8% of the GDP in third quarter of 2002 as against 19.45% at the end of 2001. The price of US dollar increased from a mean value of R$2.55 in the fourth quarter of 2001 to R$3.67 in the fourth quarter of 2002, implying a 43.9% change in the period (Meirelles, 2003). The monetary policy decisions throughout 2002 were based on comparison between inflations and the adjusted target. During the first quarter of 2002, favorable economic scenario with a stabilized exchange rate of around R$2.40, Copom reduced the celic rate target by 0.25 p.p., setting the selic rate at 18.5% p.a. from March onwards. Another reduction of selic rate to 18% p.a., occurred in July. Up to this time, although inflation projection for 2002 was somewhat higher than the adjusted target, but it was within the tolerance limit set by the CMN. Copom decided to maintain the selic rate at 18% in August and September as the inflation projections for 2003 were in line with the adjusted target. However, between September 16 and October 11, the median of inflation expectations for 2003 surveyed by Gerin increased to 5.85% from 5.20%. The consequent increase in the selic rate was 21% p.a. Projection of a further deterioration of market expectations for 2003 inflation to almost 11% in December, led Copom to further increase the selic rate at 25% p.a. at the end of the year. Source: www.businessweek.com Throughout the year 2002, the Central Bank aimed at neutralizing half of the inflation inherited from the previous year. The Central Bank was able to control inflation expectations for the majority of the year, except the final quarter of 2002. However, 2002 inflation stood 9.0 p.p above the target, the forecast inertial impact on 2003 inflation is 4.2 p.p., which is considered excessively high and require more gradual reduction. For 2004, the adjusted inflation target is 5.5%. The Central Bank calibrates monetary policy based on the evaluation of the future trend of inflation. This evaluation entails more subjective analysis in the form of best available information through structural models, simulations and other statistical measures and qualitative and disaggregate measures as well. When the projections indicate that there is divergence of inflation from the target, the Copom reviews the cause of the increase in the projection to define the convergence trajectory of inflation towards the pre-set target. Banco Central do not follow a policy of achieving the target irrespective of costs but considers the nature and persistence of the shock and the costs regarding the level of activity (Banco Central, 2003). The Banco Central operates with the concept of an adjusted target, in which the primary effect of the shock to administered and monitored price inflation, and inflation inertia inherited from the previous year to be accommodated in the current year, are added to the target previously set by the CMN. The Banco Central do Brasil which, is committed to an inflation targeting regime, concentrates on the assessment of future inflation behavior and its convergence to the established targets while pursuing its monetary policy. While pursuing the inflation for 2003, the Central Bank of Brazil sought an inflation path which led to significant disinflation and bought inflation down to the tolerance intervals of the inflation target two years ahead. While determining the disinflation strategy, the Central Bank took into account the economic activity perspectives to avoid significant output losses. The adjusted inflation target for 2003 and 2004 is shown in the following table: Itemization 2003 2004 a) Target for inflation set by CMN 4.0 3.75 b) Administered and monitored price shock1 1.7 1.1 c) Inertia to be fought in following years2 Inherit inertia from previous year (total) Of administered prices Of market prices 2.8 4.2 1.4 2.8 0.6 1.0 0.4 0.6 d) Adjusted targets (=(a)+(b)+(c) 8.5 5.5 1) For the calculation of the shock, the effect of inertia and exchange rate on administered and monitored prices inflation is deducted. 2) The inertia to be fought in the following years corresponds to 2/3rd of the inertia inherited from the previous year. Source: Banco Central Report, 2003 In the first quarter of 2003, there was a reversal of the confidence crisis as a result of fiscal stance taken by authorities to generate public sector's primary surpluses along with inflation targeting regime. The first quarter of 2003 saw higher rate of inflation as a result of inertia effect of contaminated prices of last quarter of 2002 as well as impact of exchange rate depreciation during that period. However, since mid 2003, inflation returned to low and stable level. After an unusual deflation of 0.15% in June, inflation in the second half was 2.49%, equivalent to an annual 5.04% rate. At the end of December 2003, inflation expectation for 2004 and 2005 stood at 6.0% and 5% respectively. In the year 2004, the main determinant of inflation was wholesale and consumer price index, high levels of industrial capacity utilization and volatile international oil price. Taking into consideration the above factors, Copom held the selic rate at 16.00% from April to August. In September, the monetary policy committee has decided to initiate a process of moderate monetary policy adjustment, raising the basic interest rate to 16.25% per year. Inflation measured by IPCA for January to August 2004 period was 5.14%. The distinguishing feature of the internal macro economic scenario in the third quarter of 2004 was a confirmation of a sharp upturn in the pace of economic activity as evident by output, sales and employment indicators announced during the period. In its September meeting, Copom decided to calibrate the monetary policy in a way so as to achieve 5.1% IPCA inflation in 2005. This entails adding 0.6 p.p. to the central target of 4.5% set by the CMN, corresponding to absorption of 2/3 of inflationary inertia that will be transmitted from 2004 to 2005 (Inflation Report, 2004). In 2005, contrary to expectations at the beginning of the year for a slowdown of economic activity due to acceleration of inflation and to the tighter monetary policy stance implemented since September, 2004, in the second quarter the economy posted its strongest performance since the first quarter of 2004. IPCA inflation accelerated in the first four months of the year, reaching 0.87% in April, but cooled down in May through August. The brisk pace of economic activity in the second quarter of 2005 reflects, in part, a strong recovery in fixed capital formation. Taking into account the international financial markets, and recent spike in oil prices, Copom held the selic rate target steady at 19.45% in July-August 2005 and then reduced it to 19.50% in September. This easing followed nine consecutive selic rate increases (from September 2004 to May 2005) which delivered a cumulative tightening of 375 basic points (Inflation Report, 2005). The IPCA inflation in August 2005 was 3.59%, the lowest value recorded for this period since 1998. Twelve month trailing inflation in August was 6.02%, down from the peak of 8.07% reached in April. In the May-August period, monthly average IPCA inflation 0.22%, down from 0.66% in the four preceding months. The IPCA diffusion index fell to 48.7% in August, the lowest level registered for that month since 1998, signaling that reduction in inflation has been broad based (Inflation Report, 2005). In the first quarter of 2005, the market inflation expectations was relatively unaffected by favorable developments, indicating stabilization of inflationary pressures that is characterized by slow down in economic activity, drop in wholesale industrial prices, revision to market exchange rate expectations and the more restrictive monetary policy stance since September 2004. Inflation expectation in 2005 rose from 5.77% in mid March to 6.39% in mid May. In the 2nd week of September, expectations have fallen considerably to 5.19%. This indicated that the inflation expectations are moving closer to 5.10% inflation objective for the year. Inflation expectation for 2006 declined to 4.98% in August and 4.80% in September, after holding steady at 5.00% for 64 consecutive weeks. In addition, the distribution of 2006 inflation expectations has moved toward a mode that is closer to the target established by the CMN. These development suggest that the monetary tightening implemented since September 2004 has both contained short-term inflationary pressures (Inflation Report, 2005). To conclude, Banco Central of Brazil took the responsibility entrusted upon it seriously. High inflation anticipated by many after the real had been forced to float in 1999 was avoided. The central bank has tightened monetary policy on several occasions when inflation has moved above the target range. The central bank's resolve was certainly tested by the severe crisis of confidence in 2002 that led to a sharp decline in the exchange rate. Inflation did rise to over 12%, which was well above target. But tight monetary policies supported by effective fiscal discipline gradually brought inflation back to within single digits (Knight,2005). References Banco Central do Brasil (2005) Inflation outlook, 2005, retrieved from the website: http://www.bcb.gov.br/INFLAREPORT, updated on 2/12/2005 Banco Central do Brasil (2004) Inflation outlook, 2004, retrieved from the website: http://www.bcb.gov.br/INFLAREPORT, updated on 2/12/2004 Bogdanski, J., Tombini, A.A., and Werlang, S.R.C. (Implementing Inflation Targeting in Brazil, retrieved from the website: http://www.brasilemb.org/profile_brazil/bogdanski.pdf dated 25th March, 2006. Fraga, A (2000) Monetary Policy During the Transition to a Floating Exchange Rate: Brazil's Recent Experience - IMF Publication, retrieved from the website: http://www4.bcb.gov.br/ARTICLE001 Knight, Malcom, D (2005) Features of an effective central bank: some lessons of the past decade, Bank for International Settlements. Retrieved from the website: http://www.bis.org/speeches/sp050330.htm Minella, A., de Freitas, P.S., Goldfajn, I., Muinhos, M.K. (2003) Inflation targeting in Brazil: constructing credibility under exchange rate volatility, Journal of International Money and Finance, vol.22, pp. 1015-1040 Bevilaqua, A., and Loyo, E (2005) Brazil's stress test of inflation targeting, BIS papers no.23, retrieved from the website: http://www.bis.org/publ/bppdf/bispap23f.pdf on 26th March, 2006. Read More