The Central Bank's extravagant interest rate policy

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By PAULO NOGUEIRA BATISTA JR.*

The arguments in defense of the generous interest rates that the market so appreciates and that favor it so much are doubtful.

1.

I return to writing about the Central Bank's extravagant interest rate policy. The subject is vast; I will stick to what seems most relevant in the current Brazilian situation.

I start with the division of the Central Bank board. Before the most recent meeting of the Central Bank's Monetary Policy Committee (Copom), the media announced a fight of epic proportions. On the one hand, the conservatives, defending a 0,25 percentage point reduction in the Selic, the basic interest rate. On the other, the revisionists, fighting for a decrease of 0,5. The conservative group prevailed, with five votes, against the minority group, the four directors appointed by President Lula.

But it was, in fact, a Battle of Itararé. Between dead and injured, everyone was saved. The minutes of this Copom meeting, as expected, used the usual “central bank” to calm tempers and reestablish concord among the nine illustrious members of the collegiate.

The underlying problem persists, however. In December, the mandate of the current president of the Central Bank ends – which is a reason for hope and fear. Hope for us, who want a change in monetary policy orientation. Fears for the smugglers, always clinging to exorbitant interest rates.

What does the market want? Ideally, Roberto Campos Neto continues or, which would amount to the same thing, that he is replaced by another senior official in the financial system, one of those who follow the script and do not threaten established interests.

If this is not possible, and just in case, the scoundrels try to intimidate the government, especially the Minister of Finance. It makes you feel, in various ways and through various channels, that the choice cannot fall on an unpalatable name. If the successor cannot be one of them, let him be a harmless and co-optable figure.

The corporate media, which always echoes the concerns and interests of the financial market, has long predicted, without much joy, that Gabriel Galípolo will be the next president of the Central Bank. Galípolo has an unusual profile – heterodox economic background, but with experience in the financial system. He was one of the four who preferred a 0,5 percentage point cut at the last Copom meeting. He probably led the splinter group.

In fact, it seems to me that they set a little trap for him. They took advantage of some of his statements that were slightly “outside the box” to stigmatize him as a little irresponsible and subject to the government's political influence. Roberto Campos, in contrast, would be “technical”, “responsible” and “independent”. Nonsense. However, the Copom score, 5 to 4, helped to give some support to this narrative.

2.

But let's leave these tactical moves aside. There are more fundamental questions, among others the following: why does the BC insist so much on the high interest rate policy? Is it possible to justify it?

The side effects are many and unpleasant. Monetary policy harms public finances at the cost of government debt, hinders economic growth and capital formation, and causes concentration of national income. The arguments in its favor would have to be very strong. And they are? Let's see.

The Central Bank's argument essentially has two parts. The first is that its primary task, established by law, is to conduct interest policy in order to achieve the inflation targets defined by the National Monetary Council (CMN). Under current legislation, the Central Bank should only be secondarily concerned with the effects of its policy on activity and employment levels. In other words, Brazilian law establishes a dual, but asymmetric, mandate for the Central Bank. In practice, the focus is on inflation.

The second part of the argument is that the macroeconomic models adopted by the Central Bank would indicate, supposedly with some certainty, that the high level of the Selic is indispensable to guarantee the convergence of inflation to the targets set by the CMN. The adverse effects of monetary policy on economic activity, the public deficit and income distribution would be the price to pay to keep inflation within targets.

This argument may seem solid, it has a lot of support in the financial market, the media and traditional academic circles. And yet, it is not difficult to understand its weaknesses.

The fact that the Central Bank is not simply an executor of goals set by the CMN is often omitted. The president of the Central Bank is one of the three members of the Council, the other two being the Ministers of Finance and Planning. The latter tends to have less weight because it is distant from monetary matters. Currently, as Minister Simone Tebet is not from the sector, Planning's influence is even less than usual.

In addition, the Central Bank acts as the secretary of the Council. As any experienced person knows, whoever serves as secretary of a body has a decisive influence on its deliberations. Thus, I repeat for the umpteenth time, the Central Bank, to a large extent, sets targets for itself. This was one of the “outside the box” questions raised by Gabriel Galípolo shortly before the most recent Copom meeting.

Furthermore, and perhaps more relevant, the question arises: would inflation targets not be excessively ambitious, contributing to high interest rates? President Lula asked this question publicly a few times. There was no convincing answer. If the center of the inflation target were a little higher and the tolerance interval (the distance between ceiling and floor) a little wider, wouldn't the Central Bank have more room for maneuver to soften interest rate policy?

The target for 2025, for example, is 3% with a tolerance range of 1,5 pp up and down. A modest adjustment of the targets, establishing, say, a target of 3,5%, with a tolerance interval of 2 pp up and down would hardly pose a risk of uncontrolled inflation and would favor the practice of more civilized real interest rates.

But not only that. What model or models are these that generate the need to keep interest rates always in the stratosphere? Every economic model involves a considerable dose of uncertainty. Anyone who has experience in this area knows that they are not able to give univocal answers to the main questions. This is why, in fact, Central Banks never rely solely on models and the projections derived from them. To make decisions, they observe a whole set of variables, indicators and information.

Now, many of these indicators suggest that it would indeed be possible to ease monetary policy more quickly. Given the uncertainties that always surround the issue, controversy is inevitable and tends to be fierce. In favor of reduction, the following evidence can be aligned, among others. The current inflation rate is under control and does not show an upward trend. For this year and next, inflation projections do not indicate a major difference in relation to the targets.

The economy has idle capacity in industry and high rates of worker unemployment (especially in the broadest definitions of unemployment). Finally, there is a lot of slack in the balance of payments, which allows imports to be expanded with ease. The catastrophe in Rio Grande do Sul, like all supply shocks, puts pressure on inflation and brings down production, but does not radically change, as far as can be seen, the national economic picture.

Bad news for the militant gang of buffoons: the arguments in defense of the generous interest rates that they so much appreciate and that favor them so much seem doubtful. Good news for those unhappy with the current monetary policy: interest rates could be lower, with a beneficial impact on economic activity, employment, public debt and income distribution.

*Paulo Nogueira Batista Jr. is an economist. He was vice-president of the New Development Bank, established by the BRICS. Author, among other books, of Brazil doesn't fit in anyone's backyard (LeYa) [https://amzn.to/44KpUfp]

Extended version of article published in the journal Capital letter, on May 17, 2024.


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