To start, the impact of monetary policy on inflation is not swift, it takes at least three trimesters in the Brazilian experience. The interruption of the loosening of the interest rate must happen therefore way before the economy starts to show some warming up and inflation is close to the planned.
On account of this, the behavior of the economy by itself is not enough to take monetary policy decisions, making central banks seek other “instruments of navigation”. Using econometric techniques, they estimate variables that are not directly measurable, but are important concepts developed by the economic literature, such as neutral interest rate and output gap.
The neutral interest rate is that which keeps inflation stable. Countries like Brazil, with deficit and high public debt and low savings rate, have a higher neutral interest rate. When the economy is weak and inflation low, the Copom sets the Selic rate below the neutral level (expansionist policy), and vice versa (contractionist policy).
The output gap measures the idleness of resources (capital, labor, infrastructure) in the economy. It is a guide to define how much should you stimulate (or contract) the economy. To estimate these variables is a particularly challenging task in Brazil, especially due to so many economic shocks.
The current situation doesn’t help. The Central Bank still has to deal with the uncertainties of the economic agenda of the next government, which reduces the visibility of the inflation trajectory of next years. Inflation projection models become less reliable. If the fiscal situation were more comfortable, with the social security reform approved, the uncertainties would be smaller.
In the midst of all of these difficulties, the Central Bank needs to choose which risk they prefer to take: of cutting too much the interest rate and end up generating unwanted inflationary pressure or to not cut enough and slowing down economic recovery, with inflation below the target for a long period.
There are reasons to believe it is worthwhile, for now, to take the first risk.
Firstly, it is possible that the neutral interest rate is falling, being in the 3.5% zone in real terms (discounting inflation), compared to estimates around the 5.0%. The reason would be the change in economic policy and the credibility of the Central Bank.
The budget deficit is enormous, but reflects the rigidity of spending and the increase of social security spending, while during the Rousseff government it was fiscal stimulus “straight to the veins”. Almost 5.0% of the GDP increase of the public deficit, not counting the stimulus via credit in the public banks, which increased 11% of the GDP up to 2015. It is very unlikely a repetition of this experience in irresponsible activism, because the money is finished.
Lower neutral interest rates mean less “stimulative” monetary conditions than imagined. The Selic at 6.5% p.a. would be no more than 1pp below the nominal neutral rate.
Secondly, the pace of recovery of the economy has not been sufficient to effectively reduce the output gap, which is reinforced by the reduced use of the industrial capacity and services, and the static unemployment rate. Considering the slow evolution of the credit and the financial situation of businesses and families, there seems to be no strength to change this situation in a timely manner.
As a result, inflation remains far from the planned levels and surprisingly favorable, with no pressure in sight. If the next president adopts a mediocre agenda, inflation will suffer and the Central Bank will have to reorient monetary policy.
However, there is no point in a preemptive policy now. The scenario is of political uncertainty and not certainty of a negative forthcoming scenario.