Inflation Targeting in Brazil: Challenges and Perspectives

1
Inflation Targeting in Brazil Challenges and
Perspectives

• Presented by Laurent Risler

2
Background on IT

• The three pillars of an IT regime
• An independent central bank devoted to fulfill
  inflation targets
• Given the existence of lags between policy
  decisions and their effect on output and prices,
  the monetary authority must adopt a
  forward-looking posture
• IT requires high levels of transparency and
  communication with the agents, especially when
  the inflation objectives are not met.

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Objective of the Paper

• This paper aims to evaluate the performance
  delivered by the IT regime on three bases
• Consistency of monetary policymaking Does the
  Central Bank behave in accordance with the IT
  framework?
• Performance in terms of inflation and output Has
  IT been able to stabilize inflation dynamics at a
  reasonable cost?
• Construction of credibility Do the targets work
  as an operative coordinator of expectations?

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Overview of the First Years of IT 1999-2004

• Since June 1999, macroeconomic policy in Brazil
  is composed of three key ingredients
• a floating exchange rate regime,
• sound fiscal policy, and
• the IT regime.

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Overview of the First Years of IT 1999-2004

• Naturally, among these shocks, the most delicate
  to handle for the monetary authority is the wide
  exchange rate fluctuations. An exchange rate
  depreciation induces inflationary pressures
  through different channels.
• Directly, it affects prices of commodities whose
  prices are "administered" and linked to the
  exchange rate (oil-by products, electricity
  fees).
• Indirectly, it may stimulate demand (foreign and
  domestic) for domestic goods and services.
• The channel through which exchange rate
  variations affect prices is referred to as the
  exchange rate pass-through.

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Reaction Function of the Central Bank

• Minella et al. (2003) suggest the following
  linear regression
• it a0 a1it-1 a2(Etptj ptj) a3yt-1
  a3yt-1 a4?et-1 a5?mt-1 et

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Reaction Function of the Central Bank

• From an overall perspective, our results suggest
  that the Central Bank has acted consistently with
  the IT framework.
• First, the relatively high and significant value
  of the coefficient on the lagged interest rate
  (between 0.65 and 0.80) suggests that the Central
  Bank of Brazil attempts to smooth interest rate
  variations.
• The point estimates of the coefficient on
  inflation expectations (formed by the market or
  the Central Bank) are also significant in every
  specification. That is, the monetary authority
  reacts to inflation expectations it conducts
  monetary policy on a forward-looking basis.

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The Determinants of Inflation Expectations

• A natural way to address the effectiveness of the
  inflation targeting framework consists of
  investigating whether private expectations are
  driven by the inflation targets. In this
  perspective, we seek to determine whether
  expectations are regressive.
• Expectations formation is called regressive when
  a variable is expected to close any gap between
  its current level and its long-run equilibrium
  level.

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The Determinants of Inflation Expectations

• We argue here that if monetary policy is
  credible, the inflation target ought to guide
  private expectations and play the role of a
  medium-run equilibrium value. Therefore, we
  decided to test the following inflation
  expectation form
• ?pet1 a0 a4?et a2(pt pt) a3?et et

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The Determinants of Inflation Expectations

• The results provide pertinent information on the
  way agents form their anticipations.
• The results globally look fairly good. All
  coefficients have the expected sign and are of
  plausible magnitude.
• Naturally, the first notable conclusion is that
  inflation expectations seem to be regressive the
  estimate of the coefficient on the deviation of
  inflation from the target is significant and
  relatively large. This outcome suggests that
  inflation targets exert a substantial influence
  on private expectations.
• Moreover, the variation in the nominal interest
  rate is both statistically and qualitatively
  relevant. Once again, this may show that the
  Central Bank is establishing some credibility.
  Indeed, agents clearly incorporate its actions
  when they form their expectations.
• Nevertheless, the fact that agents take into
  account the fluctuations of the spot rate
  suggests that they consider other factors that
  are liable to produce inflationary pressures. In
  particular, they doubt the ability of the
  monetary authority to control the exchange rate
  pass-through.

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The Effect of Inflation Targets on Inflation

• The object of this final section is to evaluate
  whether inflation targets affect inflation
  dynamics. Intuitively, if monetary policy is
  credible, a reduction of the inflation target
  should lead to a fall in the inflation rate. In
  order to measure the response of inflation to
  innovations in the targets, we will use the VAR
  model formulated by Schmidt-Hebel and Werner
  (2002). Before describing their assumptions, let
  us briefly recall the main characteristics of VAR
  models.

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Brief Background on VAR Models

• A Vector Autoregression (VAR) model is a
  n-equation, n-variable linear model in which the
  current value of a variable is explained by its
  own lagged values, plus current and past values
  of the remaining n-1 variables. This simple
  framework provides a systematic way to capture
  rich dynamics in multiple time series.

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Brief Background on VAR Models

• Impulse responses trace out the response of
  current and future values of each of the
  variables to a one unit increase in the current
  value of one of the VAR errors, assuming that
  this error returns to zero in subsequent periods
  and that all other errors are equal to zero.

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Brief Background on VAR Models

• A recursive VAR constructs the error terms in
  each regression equation to be uncorrelated with
  the error in the preceding equations. This is
  done by judiciously including some
  contemporaneous values as regressors.

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Brief Background on VAR Models

• Consider our six-variable VAR, ordered as (1)
  output growth, (2) the inflation rate, (3) the
  rate of depreciation, (4) money growth, (5) the
  nominal interest rate, and (6) the inflation
  target.
• In the first equation of the corresponding
  recursive VAR, output growth is the dependent
  variable and the regressors are lagged values of
  all six variables.
• In the second equation, inflation is the
  dependent variable and the regressors are lags of
  all six variables plus the current value of
  output growth. The nominal exchange rate
  variation is the dependent variable in the third
  equation, and the regressors are lags of all
  three variables, the current value of output
  growth, plus the current value of the inflation
  rate and so forth...

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The Effect of Inflation Targets on Inflation

• The figure shows the impulse response to a one
  standard deviation of inflation target shock and
  the two-standard-error bands which were estimated
  using a Monte Carlo experiment with 1000 draws.
• As expected, the inflation rate rises in response
  to an unanticipated increase in the inflation
  target. However, the response, is statistically
  barely significant. This suggests that the
  Central Bank is still in the process of
  establishing credibility, a process that requires
  time. Obviously, a lot remains to be done to
  qualify this experience as a success.

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Conclusion

• It is certainly too early to form a definitive
  assessment of this regime. Nonetheless, several
  lessons may be learnt from the Brazilian
  experience. Even though, the inflation targets do
  not seem to affect price changes, our empirical
  work suggests that inflation targeting has had
  certain positive repercussions.
• We first observed that the monetary authority has
  adopted a forward-looking posture by
  incorporating private forecasts in its actions.
• But the most convincing success of the regime is
  its role in the expectation formation process.
  Indeed, the targets serve as a medium-run
  equilibrium value towards which private agents'
  expectations tend to converge. The publicly
  announced targets have therefore worked as an
  effective anchor for expectations.