Inflation outlook and monetary policy

In a recent editorial, we argued that the increase in monthly inflation rates in July and August did not constitute a continuous and generalized increase in the price level resulting from excessively loose monetary conditions. Despite the significant decline in real interest rates over the last two years, one can hardly claim that monetary expansion was excessive. Nor does it seem likely that this will occur, at least based on the repeated demonstrations of the government's commitment to the fiscal adjustment (often, a fiscal imbalance lies at the root of an inflationary episode).

The inflationary spike was clearly associated to supply shocks, associated to localized and easily identifiable events, such as the readjustment of public utility and fuel prices, or the impact of adverse weather conditions on some agricultural products. In the short term, monetary policy cannot ward off such movements. However, in the medium term, it can stop such localized shocks from spreading through the remainder of the economy (that is, from becoming a traditional inflationary episode).

This is the context in which one should look at the Central Bank's decision to maintain the SELIC target rate unchanged at last week's COPOM meeting (for the second consecutive month). This was a preventive measure, not aimed at meeting the 2000 inflation target, but rather, in order to ensure that the 2001 inflation target (4%) will be met. After all, one should not forget that today, the Brazilian economy is operating at a substantially higher level of installed capacity utilization than was the case one year ago; that labor market conditions are beginning to improve at a more solid pace; and that Brazil is currently subject to sizeable cost pressure due to the rise in oil prices.

A closer look at the recent behavior of industrial wholesale prices helps illustrate this point. Year to date through August, the accumulated variation of the IPA-Industrial stands at 8.5%. About half of that can be attributed to increases in domestic fuel prices and their impact on the production chain. However, even if we exclude the impact of fuel prices, there was significant pressure on the price of goods produced in other sectors of the economy, such as paper and corrugated cardboard, steel products, non-metal minerals. The price of all these items rose at an annualized rate of about 8.5%, pressuring the cost structure in several industries. Most of these cost increases have not been passed on to final consumer prices, but this could change over the next eighteen months, especially if one considers that economic growth is expected to accelerate over the period. This increases the importance of assessing the behavior of core inflation, even if there is still no consensus over the most appropriate measure of core inflation.

During next year, agricultural crops are expected to grow by about 5-10% (assuming normal weather conditions), with stronger growth in the production of corn and livestock. This allows one to assume that the harvest season will exert downward pressure on food prices during the first half of the year. Even if we do not expect the particularly strong decline in food prices observed at the beginning of 2000 (which allowed the YTD IPA-Agricola to reach just 1.6%) to be repeated in 2001, it is feasible to work with a scenario where core inflation will rise at an annualized rate of about 5%, similar to what is being observed in 2H2000, reflecting slightly stronger pressure on the price of industrialized goods and services.

Based on this scenario, the outlook for the BCB's interest rate policy is considerable worse than had been the case only one month ago. There is probably still room for the SELIC target rate to be lowered to about 16% by the end of the year (although even this small interest rate cut cannot be taken for granted), assuming that the exchange rate remains stable at around R$1.85/USD over the next few months, but it is difficult to imagine the SELIC beneath 16% still in 2000.

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