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Inflation Targeting in Brazil
Meeting of Governors of Latin America and Spain
Henrique de Campos Meirelles
Washington
October 2004
1
Inflation Targeting in Brazil
I. Background
II. 1999-2000: Building Credibility
III. 2001: Target Miss
IV. 2002: Sudden Stop
V. 2003-2004: Disinflation Strategy
VI. What Have We Learned?
2
Inflation Targeting in Brazil
I. Background
3
Background
 In 1994, successful monetary reform reduced annual
inflation from nearly 2,500% to single-digit rate;
 Monetary reform was accompanied by incomplete fiscal
adjustment;
 Deepening external disequilibrium (overvalued exchange
rate);
 External crises in the mid-90s (Mexico, Southeast Asia and
Russia) gradually increased vulnerability of the Brazilian
economy, with significant losses of international reserves
to sustain the peg.
4
Consumer Inflation Rate: 1992-1998
%
2,477.1
1,119.1
916.4
1992
1993
1994
22.4
9.6
5.2
1.7
1995
1996
1997
1998
5
Consolidated Public Sector
Primary Surplus: 1992-1998
6
5.0
5
% of GDP
4
3
2.3
2.6
2
Incomplete fiscal adjustment
1
0.4
0.0
0
-0.1
-1
-0.9
1992
1993
1994
1995
1996
1997
1998
6
Current Account: 1992-1998
2
1.6
1
% of GDP
0
-0.2
-0.3
-1
-2
-2.6
-3
-3.0
-4
-3.8
-4.2
-5
1992
1993
1994
1995
1996
1997
1998
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Inflation Targeting in Brazil
II. 1999-2000: Building Credibility
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1999-2000: Building Credibility
 January 1999: Floating exchange rate regime  search
for a new nominal anchor  Inflation Targeting regime
formally adopted in June 1999.
 Initial targets established when regime was implemented
implied strategy of fast disinflation:
• 1999: 8% +/- 2%
• 2000: 6% +/- 2%
• 2001: 4% +/- 2%
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1999-2000: Building Credibility
 Inflation rate stood at 8.9% in 1999 and 6.0% in 2000,
within target range.
 However, fulfilment was not an easy task due to:
 Initial inflation expectations well above target;
 Exchange rate depreciation of 48% during 1999, and
of 9.3% during 2000.
 Pressure from backward-looking regulated prices
(utilities representing about 30% of consumption
basket), with rises of 20.9% in 1999, and of 12.9% in
2000.
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Nominal Exchange Rate: 1999-2000
2.25
2.00
R$/US$
1.75
1.50
1.25
1.00
0.75
Jul
94
Jan Jul
95 95
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
96 96 97 97 98 98 99 99 00 00
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Consumer Inflation Rate: 1999-2000
Central inflation targets
1999: 8.0%
2000: 6.0%
10
8
%
6
4
2
0
Jan
97
Jul
97
Jan
98
Jul
98
Jan
99
Jul
99
Jan
00
Jul
00
12
Inflation Rate, Regulated and
Market Prices: 1999-2000
Market Prices
Consumer Inflation
Regulated Prices
25
20.9
%
20
15
12.9
10
8.9
6.4
6.0
5
3.7
0
1999
2000
13
1999-2000: Building Credibility
 Causes for low pass-through and initial success of IT
regime:
• Widespread anticipation of devaluation;
• Currency clearly overvalued before floating;
• Low initial inflation level.
• No significant currencies mismatch in the private
or banking sector due to provision of hedge by
Government  main cost of devaluation was the
increase of debt/GDP ratio;
14
Debt/GDP Ratio: 1999-2000
52
% of GDP
47
42
37
32
27
Jul
94
Feb
95
Sep
95
Apr
96
Nov
96
Jun
97
Jan
98
Aug
98
Mar
99
Oct
99
May
00
Dec
00
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Inflation Targeting in Brazil
III. 2001: Target Miss
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2001: Target Miss
 2001 marked by external shocks (Argentinian crisis,
9/11, increase in risk aversion) and a domestic
adverse supply shock (energy rationing) ;
 Exchange rate depreciation by nearly 44% in the peak
of the year and 19% on average for the calendar year;
 Like in previous years, inflation also pressured by
regulated prices changes, especially electricity rates;
 Inflation at 7.7% missed the 4% + 2% target.
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Nominal Exchange Rate : 2001
3.00
2.75
2.50
R$/US$
2.25
2.00
1.75
1.50
1.25
1.00
0.75
Jul
94
Mar
95
Nov
95
Jul
96
Mar
97
Nov
97
Jul
98
Mar
99
Nov
99
Jul
00
Mar
01
Nov
01
18
Consumer Inflation Rate: 2001
10
8
Central inflation target
2001: 4.0%
%
6
4
2
0
Jan 97 Aug 97 Mar 98 Oct 98 May 99 Dec 99
Jul 00 Feb 01 Sep 01
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Inflation Targeting in Brazil
IV. 2002: Sudden Stop
20
Capital Inflows
(US$ billion)
61.7
52.8
US$ 8.9 billion
GAP
US$ 28.0 billion
GAP
24.8
2000
2001
2002
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2002: Sudden Stop
 Confidence crisis triggered by uncertainties regarding
macroeconomic policies of new government;
 Exchange rate depreciation by 53% over the year,
concentrated in the 2nd half;
 As in 2001, large exchange rate depreciation jeopardized
inflation target;
 Inflation peaked in the last quarter and contaminated
long-term inflation expectations. Consumer inflation
ended the year at 12.5%, missing the 3.5% + 2% target;
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Brazil Risk: 2002
23
Nominal Exchange Rate: 2002
4.25
3.75
R$/US$
3.25
2.75
2.25
1.75
1.25
0.75
Jul
94
May
95
Mar
96
Jan
97
Nov
97
Sep
98
Jul
99
May
00
Mar
01
Jan
02
Nov
02
24
Consumer Inflation Rate: 2002
Central inflation target
2002: 3.5%
13
11
% p.a.
9
7
5
3
1
Jan
97
Aug
97
Mar
98
Oct
98
May
99
Dec
99
Jul
00
Feb
01
Sep
01
Apr
02
Nov
02
25
Inflation Expectations: 2002
13
2002
%%
11
2003
2004
9
7
5
3
Jan
02
Feb Mar
02
02
Apr
May
Jun
Jul
Aug
Sep
Oct
02
02
02
02
02
02
02
Nov Dec
02
02
26
Inflation Targeting in Brazil
V. 2003-2004: Disinflation Strategy
27
2003-2004: Disinflation Strategy
 New government committed to fiscal sustainability
(target for consolidated primary surplus at 4.25% of
GDP for 2003 and at 4.5% of GDP for 2004).
 Government
pursued
agenda
of
reforms:
social
security, tax reform, new bankruptcy law, among others.
 Continued FX depreciation since 1999 reduced the
current account deficit by nearly 6.5% of GDP in 2001-
2004, especially due to substantial increase in exports
(current account went from a 4.6% of GDP deficit to a
1.8% of GDP surplus).
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Consolidated Public Sector
Primary Surplus: 1999-2004
4.9
% of GDP
5
4.4
4
3.3
3.5
3.7
4.0
3
2
1
0
1999
2000
2001
* 2004: 12 months up to August 2004
2002
2003
2004*
29
Current Account: 1999-2004
1.8
2
% of GDP
0.8
0
-2
-1.7
-4
-4.0
-4.6
-4.7
-6
1999
2000
2001
* 2004: 12 months up to August 2004
2002
2003
2004*
30
Brazil Risk: 2003-2004
2,400
Basic Points
2,100
1,800
1,500
1,200
900
600
300
Jan
95
Jul
96
Jan
98
Jul
99
Jan
01
Jul
02
Jan
04
31
Nominal Exchange Rate: 2003-2004
4.0
3.5
R$/US$
3.0
2.5
2.0
1.5
1.0
0.5
Jul
Jun
May
Apr
Mar
Feb
Jan
Dec
Nov
Oct
Sep
Aug
94
95
96
97
98
99
00
00
01
02
03
04
32
2003-2004: Disinflation Strategy
 Credibility challenge  use of adjusted inflation target
methodology (accommodation of 2/3 of inertia from
previous year and first round effect of supply shocks
during the year). Adjusted target set at 8.5%;
 Central targets for 2004 and 2005 at 5.5% and 4.5%,
respectively, with tolerance intervals of +/-2.5%.
 Inflation fell to 9.3% in 2003, compared to market
inflation expectations of around 12.5% in beginning of
the year.
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Consumer Inflation Rate: 2003-2004
17.5
Adjusted inflation target 2003: 8.5%
Central inflation target 2004: 5.5%
15.5
13.5
% p.a.
11.5
9.5
7.5
5.5
3.5
1.5
Jan Aug Mar Oct May Dec Jul Feb Sep Apr Nov Jun Jan Aug
97
97
98
98
99
99
00
01
01
02
02
03
04
04
34
Inflation Rate, Regulated and
Market Prices: 2001-2004
Market Prices
Consumer Inflation
Regulated Prices
18
16
15.3
14
12
%
13.2
12.5
10.8
11.5
10
8
9.3
7.7
7.8
6.8 7.2
6.6
8.1
6
4
2
0
2001
2002
* 2004: 12 months up to August 2004
2003
2004*
35
Inflation Expectations: 2003-2004
13
2003
2004
2005
12
11
%%
10
9
8
7
6
5
4
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
03
03
03
03
03
03
04
04
04
04
04
36
2003-2004: Disinflation Strategy
 Fast improvement in fundamentals enabled the
Government to actively reduce public sector’s FX
exposure;
 Also, Government started a process of international
reserve accumulation.
37
FX-Linked Domestic Debt
Outstanding: 2003-2004
Since Jan/2003, FX-linked
78
debt decreased
74
70
US$31.6 billion
66
62
58
54
50
46
42
38
34
Nov
99
Jul
00
Mar
01
Nov
01
Jul
02
Mar
03
Nov
03
Jul
04
38
Net International Reserves: 2003-2004
35
US$ billion
30
25
20
15
10
Nov
99
May
00
Source: Bacen
Nov
00
May
01
Nov
01
May
02
Nov
02
May
03
Nov
03
Aug
04
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Inflation Targeting in Brazil
VI. What Have We Learned?
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What Have We Learned?
 Disinflation requires continuous effort;
 Brazil has experienced large adverse shocks in the
recent past, which made the attainment of inflation
targets more difficult;
 A high degree of transparency and a good
communication strategy can maintain credibility
even in such environment.
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Inflation Targeting in Brazil
Meeting of Governors of Latin America and Spain
Henrique de Campos Meirelles
Washington
October 2004
42