Monetary Policy During the Transition to a Floating Exchange Rate: Brazil's Recent Experience

• Author: Arminio Fraga
• Position: Governor of the Central Bank of Brazil

The financial crisis that erupted in Asia in 1997 quickly spread to other developing regions, as international investors panicked and pulled their capital out. In this article, the governor of Brazil's central bank outlines the steps Brazil took to avert financial disaster when inflows of private foreign capital suddenly dried up.

The background to Brazil's financial crisis in early 1999 included both fiscal and balance of payments weaknesses: in mid-1998, Brazil's consolidated fiscal position was showing a primary deficit as the government's expenditures, excluding interest payments, exceeded its income. The bulk of the government's domestic debt-which amounted to 40 percent of GDP-consisted of short-term financing. The current account deficit was approaching 5 percent of GDP, even as the economy was sliding into recession. Then, as often happens to vulnerable countries, an economic crisis erupted: after Russia defaulted on its debt in August, capital flows to Brazil came to a halt.

These events forced Brazil to float the real and led to a panic in January 1999. In February, the real plummeted to 2.15 to the dollar, from 1.20 at the beginning of the year. The situation was ominous: Brazil could soon have found itself in all kinds of trouble. A panicky reaction to the devaluation could have created serious imbalances, fueling inflation while driving the economy into a deep recession. The threat of inflation was particularly relevant, given Brazil's history; observers predicted inflation rates ranging from 30 percent to 80 percent. Forecasts for GDP growth in 1999 ranged from -3 percent to -6 percent.

Curbing the panic

The first decision we faced was whether to go back to a managed peg or fixed-rate regime, or whether to float. For standard optimum currency-area reasons, we felt it made sense to allow the real to continue to float. As a result, we needed to find a new nominal anchor. A policy based on a monetary aggregate did not seem feasible, particularly considering the uncertainties inherent in the crisis sweeping through the Brazilian economy. Another possibility was the adoption of a fully discretionary policy without an explicit anchor. However, given the degree of instability expected, a stronger and more transparent commitment was essential. To address this need, we opted for a full-fledged inflation-targeting framework.

We also had to make a decision on the timing of the announcement of the inflation target. The issue was whether it made sense to announce an inflation target immediately or whether it was better to wait until the dust had settled a bit. It was too risky for us to announce a multiyear target right away. We were afraid of quickly burning what we thought was the right...