Brazil

• Author: Agnès Belaisch
• Pages: 8-9

Page 8

Brazil's crawling-peg exchange rate regime came under attack in the latter half of 1998, partly as a result of financial turmoil in other emerging markets. The Russian default in August 1998 resulted in significantly curtailing access to international capital markets for many emerging markets. ¹ In a period of presidential elections, the Brazilian Central Bank (BCB) increased short-term interest rates from 19 to 43 percent in two months to fend off a speculative attack on the real and defend the exchange rate band. However, without other supporting policy adjustments, the loss of credibility of the exchange rate regime was so strong that a large IMF program approved in December could not reverse it. After a significant loss of reserves, the BCB allowed the real to float in mid-January 1999. In the following months, inflation was selected as a formal nominal anchor and Brazil became the first inflation targeting country with an IMF-supported adjustment program. IMF staff research focused on identifying the parameters of decision making under this new monetary framework.

One key element for the BCB was to be able to determine the timing and scope for preemptive policy action when inflation was expected to deviate from its targeted path (Leone, 1999). ² Schwartz (1999; Rabanal and Schwartz, 2000a) asks whether the low pass-through of the depreciation of the real to domestic prices following the float is a structural feature of the economy or only reveals a long lag in price adjustments. ³ His vector autoregression (VAR) model confirms that the exchange rate pass-through is smaller in Brazil than in other countries due to the low reliance of the economy on imports and a large output gap-it is, however, more rapid. How could monetary policy affect aggregate demand rapidly? Rabanal and Schwartz (2000b), using a VAR model, find that the overnight interbank rate (Selic) is the most effective instrument to affect aggregate demand rapidly, and that the transmission of policy works primarily through a bank lending channel. ⁴

Another crucial ingredient of successful inflation targeting is the ability to announce reliable inflation forecasts. Rabanal and Schwartz (2000c) show that VAR and Bayesian VAR models are useful tools in the case of Brazil; today these types of models complement the structural model used by the BCB to forecast inflation. ⁵ Building on the experience of Brazil, Blejer and others (2001) analyze the adjustment to program conditionality necessary when a country adopts inflation targeting. ⁶

This new monetary framework could not have worked without accompanying fiscal reform. In 1999, the government crafted a new institutional fiscal framework aimed at improving fiscal management and ensuring sustainability. Zandamela (1999) and de Mello (2002a) assess how borrowing limits, spending rules, and sanctions embedded in the Fiscal Responsibility Law (FRL) imposed fiscal discipline at the different levels of government. ⁷ Ramos (2000) simulates the medium-term path of fiscal expenditure and revenue, casts it in a macroeconomic framework, and concludes that, if the FRL is respected, projected...