Is the Central Bank targeting growth?

FOR much of the last century inflation was as prominent a feature of Brazilian life as football. It was finally tamed, first by the Real Plan of 1994 involving a new currency and fiscal measures, and then from 1999 by requiring the Central Bank, which was granted operational independence, to set interest rates to meet an inflation target. Since 2005 that target has been 4.5%, plus or minus two percentage points. So the Central Bank surprised everyone in August when it cut its benchmark rate by half a point (to 12%) even though inflation was then at 6.9%. On October 19th, the bank did the same again. So is the government of President Dilma Rousseff, in office since January, giving priority to other goals, such as sustaining growth and preventing the overvaluation of the currency, rather than keeping inflation low? And has the Central Bank lost its independence?

No, say officials, who cite two sets of reasons for the rate cuts. First, having overheated last year, the economy stalled in the third quarter, partly as a result of earlier interest-rate rises and modest fiscal tightening. The consensus forecast is for GDP to expand by only 3.3% this year. Second, the bank argues that inflation was boosted by one-off factors, such as big rises in municipal bus fares and a shortage of ethanol (widely used as vehicle fuel in Brazil). In the minutes of its August meeting, the bank’s monetary-policy committee stated that the deteriorating outlook for the world economy and falling commodity prices would put downward pressure on prices in Brazil, allowing inflation to reach the 4.5% target in the course of next year.
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There are indeed signs that inflation is starting to fall. But the government’s critics argue that by starting to cut so early and so aggressively, while inflation is still almost three points above the target, the bank has damaged its hard-won credibility. As a result, inflation expectations for the years ahead are rising. Marcelo Carvalho, an economist at BNP Paribas, reckons inflation will only fall to 5.5% by 2013 (and that assumes the bank hikes rates again). The minimum wage is due to rise by 14% or so in January and unemployment remains low. The biggest problem is that some prices and wages are indexed to last year’s inflation, a hangover from the past. “What worries me is that this is a slippery slope: the thinking seems to be that inflation of 5% or 6% is fine,” says Mr Carvalho.

The bank may yet be vindicated by outside events and turn out to have provided Brazil with a soft landing. As inflation falls, expectations will quickly follow, says Nelson Barbosa, the deputy finance minister. Certainly lower interest rates would help the country. Among the reasons why they are so high—including government borrowing, taxes on credit, and lack of competition in banking—the most powerful may be sheer inertia.

In a vicious circle, high rates depress investment, add to the government’s borrowing costs (which total some 5% of GDP) and thus its fiscal deficit (of over 2% of GDP). They also attract hot money from abroad, which has helped to make the real uncomfortably strong, hurting exporters. “We are in a bad equilibrium,” says Mr Barbosa. “We can live with this exchange rate with a lower interest rate, but not with this interest rate. One of them has to go.”

The government wants the real interest rate to fall to 2%-3%, but Mr Barbosa insists this is not a formal target. If inflation rises, the bank will hike rates again, he says. Some other central banks, including America’s Federal Reserve, have a mandate to pursue both growth and low inflation. But when it comes to inflation, Brazil is a recovering alcoholic. It needs its Central Bank to keep it on the straight and narrow.