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Monetary Policy of Brazil

Monetary Policy of Brazil

Table of Contents

What is the economic situation?

Which institution is in charge of monetary policy?

Beginning of Brazil’s Monetary Policy

Commodity Exports

Basic Budget Act

The Real Plan

What is the trend for that country’s currency?

Arguments supporting trouble ahead?

Argument supporting Recovery

How likely is high inflation?

The Story of Lula and Rousseff

The Main factors contributing to Brazil’s Inflation volatility

Inflation Targeting

Current Situation: 2017 and Onwards

Recommendations

Bibliography

What is the economic situation?

The current economic situation is rough, and Brazil is facing several economic and political issues. Key economic rates are off the chart, and corruption scandals are broadcasted daily in Brazilian media. The outlook it is not promising for the country, as it is facing the greatest crisis in its history. In order to have a good understanding of Brazil’s situation, it is necessary to look back a few years, and learn how the economic crisis has developed (Trevizan, 2017).

During the beginning of the first decade of the 2000’s, Brazil’s economy was growing rapidly. The international scenario was favourable to the Country, as exports was at its full power. Internally, production was growing, and the early stages of the populist policies implemented by Luiz Inácio Lula da Silva, the former Brazilian president who was in power from 2002 to 2010, was helping the poorest sections of the population to improve their income. It is important to notice that this Lula is part of the Partido dos Trabalhadores (PT), the Workers Party, which is known for its populist campaigns.

Their political promises involve improving the poorest parts of the society, by providing government assistance, through projects, such as Bolsa Familia that was significantly expanded, which is aimed to reduce the levels of absolute poverty and income inequality in the country. Therefore, due to this political agenda, the government expenditure has increased significantly. However, the international and domestic scenarios were favourable at the time, and soon the scenario would change drastically over the next few years.

Fast-forwarding to 2008 and 2009, the international economy has suffered dramatic changes. Several countries started to face economic contraction, caused by excessive credit concession.

In order to protect from the global instability, the country has adopted measures that at the time protected itself from being hit by the crisis. However, the fact that it defended well from it, would cause damages on the long term, leading them to a big disaster.

The government adopted measures that would boost the economy, encouraging household and business spending. One of the measures taken was reduce the interest rate. By doing this, it expected the population to spend more, rather than save money. This would make people inject more money in the economy. The second measure was to reduce the taxes, which reduced the government income, it would leave more money in circulation, and people would be able to spend more. The third measure was fiscal concession given by the government. This means that some organizations received tax benefits, in order to continue their operations, such as electricity and fuel. At the time, the government also reduced the taxes for white household appliances, which several Brazilians took advantage of it (Oliveira & Coronato, 2016).

During that time, the measures taken by the government were able to protect the country from the economic hit from the international markets. Brazil’s international trade was doing well, the price of the key exports was high, as it relies on raw commodities, such as oil, soy and iron. China’s economy was expanding significantly, and it was a huge market for Brazilian iron, along with the United States. The increase in foreign trade was one of the factors that helped the economy to be stable, while several countries were facing economic hardships.

Brazil’s foreign trade in heavily dependent on commodities, in other words, if the price and the demand for it drops, it can cause serious damages on the economy. In 2011 that was when the Brazilian economy began to sink. Despite the fact that exports were at its full capacity, with China being the top buyer of Brazilian commodities, and this foreign trade represented 14% GDP at the time (Garcia, 2016). However, when Lula left the presidency in 2010, the economy started to show signs of problems. Even though the foreign trade was doing exceptionally well, the domestic productivity did not grow as much as intended. When the Chinese economy started to slow down, this caused the government to rethink some of the political measures taken.

As a consequence of high government expenditure, and reduced income, the problems with the Brazilian economy started to show its first signs of problems. The public accounts were unbalanced. However, for the Workers Party (PT) keep telling the promise that this would be temporary. Better times was promised during campaign, as the new president, Dilma Rousseff was elected, as a successor of Lula. She intended to continue his social assistance programmes, but the instability made it hard for her to keep her political campaign. The country was starting to face its early stages of the crisis.

During Dilma Rousseff’s mandates, the public debt increased greatly. In 2014 it grew from 51.3% to 57.2%, and in 2015 it went to 66.2% (Garcia, 2016). This causes a difficult situation for the country, because associated with a high interest rate, can increase the chances of default, in the eyes of investors. Another problem faced by Brazil at the time was the price of the commodities. As China’s growth slowed down, the price of the iron decreased from $187.18 to $37.00 in 2015 (Vale, 2018). For Brazil, as an economy highly dependent on raw materials, it was a recipe for economic hardships.

It is important to notice that Brazil is facing also a massive corruption scandal of its history. The main organization responsible for the investigation is the Federal Police, with the Operação Lava Jato, or Operation Car Wash, which since 2009 has been looking into the schemes lead by politicians and business. Through a complex system, it was deviated billions of Reais from the public safes, and especially from Petrobras, the largest government administered company in the country (Ministerio Publico Federal, 2018).

It is important to notice that despite the current economic situation of the country is terrible, it is necessary to mention the political crisis. With the help of the Operação Lava Jato, or Operation Car Wash, it is possible to know the dimension of the problem, as both economy and politics are intertwined, causing a massive chaos. Private contractor companies got together in a cartel and decided the prices between themselves for the government infrastructure operations and made then purposefully overpriced. The involved politicians facilitated the entire scheme with bribes and legislating in favor of those companies (Ministerio Publico Federal, 2018).

In light of the instability in the country, in 2015 the government promoted a very unpopular agenda of Fiscal Adjustments. Those measures were implemented by the government to hold the unbalanced accounts and increase the government income. It included increase of financial operations tax (IOF), changes in social benefits programmes, increase in gas prices, increase in imported products tax (IPI), increase in contribution of pension plans paid by business, among others (Sasaki, 2016).

The new fiscal measures proposed by the government caused a big debate among the economists. While the intention is to increase the government budget, to continue investing in the country, it can be a shot in the foot. By reducing the amount of money in the hand of the population, by increasing the taxes, and reducing the capital designated to social programmes, can cause a slowdown in the economy (Fontes, 2016).

As a consequence of this measures, the unemployment rate started to rise significantly, as it becomes costlier for employers to hire and keep workers, as a result, unemployment rate started to rise significantly. Another consequence of those measures is the lower income levels of society, which will go back to the situation they were before the social programmes were implemented (Ministerio Publico Federal, 2018).

Inflation is a problem that Brazilians started to face, also as a consequence of the ever-growing instability faced in the country. To help with it, the Central Bank decided to increase the Selic Rate, which is the base interest rate for the country. However, increasing the interest rate would help to contain the inflation, it can also be very costly to the government. In 2014 the government cost with interest rate alone was over 6% of the country GDP (Sicsu, 2015).

After the Fiscal Adjustments were implemented, it was considered a mistake by the government. It actually ended up creating more issues than benefits. Now, investing in Brazil has become unattractive. The investment risk is very high and it is hard to get capital resources to invest and stimulate the growth in the country. Brazil is facing a situation that increasing the interest rates at the moment would not benefit the country, in fact, it would only make the prices go higher (Estadao, 2015).

The political instability and the corruption scandals are affecting the country deeply. First, it affects the confidence of households and business, making them less likely to spend. Second, as a consequence of the corruption scandals, it is a natural reaction of the financial markets to crash, as a result of fear of political reforms. Third, it causes the Brazilian Real to lose value in the exchange market, as the U.S. Dollar becomes more expensive. The exchange rate caused a high impact on business debt, and increases the production cost, as imported products become more expensive and increasing the inflation. Fourth, the political instability has a high impact of unemployment rate and public debt. Lastly, it will cause a delay in the recovery process (O Globo, 2018).

With this scenario in mind, it can be understood that Brazil’s economy is facing one of the toughest periods of its history. The situation was mainly caused by the Brazilians themselves, with poor management, high expenditure, and political games. As a matter of fact, Brazil won’t be able to solve their economic issues unless it fixes its political problems (Melo & Kometani, 2017).

It can be argued that one of the main issues the country faces at the moment was the excessive focus on consumption, instead of production. By balancing this equation, it could perhaps help to solve some of the economic issues faced. Regarding the political instability, it will take years until the country solve its problems, as the corruption is ingrained in the entire system (Oliveria, 2018).

Which institution is in charge of monetary policy?

Beginning of Brazil’s Monetary Policy

Brazil’s monetary policy is run by the Central Bank of Brazil. Throughout history, Brazil has had a difficult time stabilizing their economy. In the past, dependence on commodity exports made Brazil vulnerable for macroeconomic failure. In 1994, the country embarked on a stabilization plan for their economy called the Real plan- Plano Real. Until this point, Brazil suffered from hyperinflation. Understanding the current monetary policy standpoint, it is best we look back on where it all started, and how they got to where they are today.

Commodity Exports

Before Brazil’s independence (1822), they were a colony of Portugal. During their time as a colony they used commodity exports to drive a positive effect on their economy. Sugar was the first large scale crop production established by the Portuguese. Portugal at the time had all the necessary resources to produce sugar for exporting. They had the agricultural know-how and also manufactured their own equipment to extract sugar from sugar cane. This occurred during the time of the African slave trade, therefore they had the manpower resources required. By the mid 17th century sugar exports peaked, reaching up to 90% of ALL colony exports. During this time, Portugal and the Dutch had a monopoly for sugar production and exports to Europe. Sugar was first introduced by the Portuguese to Brazil in 1530. Between 1580-1640 Portugal was incorporated into Spain, who was at war with Holland at the time. This in turn gave the Dutch an opportunity to run a sugar area in Brazil between 1630-1654, giving them control of the worlds sugar supply. In 1654, the Dutch were driven out of the sugar production in Brazil. During their time in control, they had established the required skills for sugar production thus leading to participation in the establishment of sugar in the Caribbean. The Caribbean sugar boom brought declined sugar prices to the rest of the world. Unable to compete, Brazilian sugar exports declined sharply. Although Brazil’s sugar exports declined in the 15th century, to this day, Brazil is still the largest sugar producer (US Library of Congress, 2018).

In 1690, gold was discovered by Brazilian settlers in the mountains of Minas Gerais. These settlers began enhancing this location by establishing new towns including: Ouro Preto (Black Gold) and Vila Rica (Rich Town). By the 17th century, the western world was experiencing their first gold rush.  When word spread, the population began to grow. The potential for wealth in this area drew upwards of 400,000 Portuguese and more than half a million African slaves. This entailed new problems for authorities. A lack of labour on farms was causing a food shortage. Taxes were implemented to regulate the extraction of gold. In the end, regulations and trade agreements were deemed unfavourable, therefore Portugal saw little gain from their finding of gold (Verite, 2017).

Coffee was another great commodity export for Brazil. Starting in the 1800’s, coffee consumption began to rise. In the 1840’s Brazil was exporting about 40% of coffee consumed around the globe. Brazil’s coffee exports were almost 10% of the country’s entire GDP, thus leaving Brazil very reliant on the consumption of coffee. However, between September 1926 and January 1930 the consumption of coffee declined almost 50% leaving Brazil no choice but to use their foreign exchange reserves and abandon their gold standard (Verite, 2017).

Basic Budget Act

Since independence in 1822, Brazil had gone through many changes and transformations. Political cycles alternating between dictatorial and democracy created a back and forth effect on federal power. Over time municipal governments became a better influence in the federation to the extent of being able to control basic expenditures such as education, health and town planning. In 1964, a Basic Budget Act was published (Afonso, Araújo, & Fajardo, 2016). At this time, the act was considered revolutionary. It was meant to integrate, plan and budget with financial equity management. Unfortunately, revolutionary ideas eroded over time due to military dictatorship, and hyperinflation. In 1964, the military government came into power. They had taken the opportunity to reform public finances, creating new and consistent institutions. The creation of these institutions was solid, and close to recommendations based on theory by other countries. While the reforms created by military dictatorship were in line with plans and strategies that had been developed in the past, they were implemented rigorously (Afonso, Araújo, & Fajardo, 2016). The 1960’s was a time of change for Brazil’s monetary policy. In 1964 Brazil had begun to experience their highest inflation rates thus far. That year inflation rose 144%! This led to the launch of Government Economic Action Plan.

The Real Plan

Brazil has had a long struggle with their monetary policy, and to this day they are still very cautious when it comes to making economic decisions for the country. Between May 1993-January 1999, Brazil had structured a price stabilization strategy called the Real Plan. This strategy was structured in three phases; short term fiscal adjustment, the de-indexing of the economy, and the introduction of an exchange rate anchor (Afonso, Araújo, & Fajardo, 2016).

Adjusting the short term fiscal policy had three main features; reduce expenditure, increase revenue, and reduce federal government transfers. This phase included the indexing system which made it possible for economic agents to coexist with the high inflation rates in Brazil.

The second stage of implementing the Real Plan was to eliminate inflation, and the economy’s relative prices. The previous stage, indexing made it easy to live with high inflation, but made it difficult to stop inflation. As mentioned earlier, Brazil’s currency has been ever changing through periods. During this phase, it was sought to realign these prices and incomes all in the same day with the use of an indexer which would be the same for all. This would lead to the decline of inflation.

The Real Value Unit (Unidade Real de Valor- URV) was established in March 1994. This was the tool used to realign prices. the URV remained from March 1, 1994- June 30, 1994, on July 1st, the URV was jettisoned in order to convert to a new currency. Before conversion, currency was in terms of cruzeiros reais. On July 1, 1994, 2750.00 Cruzeiros Reais equal to 1 Real (Afonso, Araújo, & Fajardo, 2016).

The third phase took place through July 1994- January 1999. The adoption of monetary targets took place, but later was replaced with exchange rate targets. As the new currency began to circulate, Brazil used a system for monetary targets in which measures included; adopting targets for the monetary base, weighting the monetary base in international reserves, setting up a fixed parity between the Real and the US dollar, and changing the CMN with regards to its composition and the transfer of its authority to issue currency.

All in all, implementing the Real plan offered great success for the Brazilian economy. In the period following 1994, inflation decreased sufficiently and remained.

Since 1999, Brazil has utilized an inflation targeting system. Inflation is controlled by fixing the basic interest rate at a level that is compatible with inflationary targets. The targets are set by the CMN (Brazil’s National Monetary Council). The Central Bank of Brazil is responsible for carrying out the policies necessary to meet the targets.

It is important to note the main indicator of the Brazilian monetary policy is called the SELIC (Sistema Especial de Liquidacao e de Custodia) rate. The SELIC rate is used as a benchmark for interest rates in the Brazilian economy. SELIC is an instrument used by the Monetary Policy Committee (Comite de Politica Monetaria- COPOM). The COPOM is made up of the managers of the Central Bank, they meet every 45 days to discuss current economic activities and also set the interest rate in regards to targeting inflation.

What is the trend for that country’s currency?

Over the last 70-80 years the Brazilian currency has faced many changes. It is one of the few countries in the world that has changed its currency over 8 times since 1942. Overall, the Brazilian currency has faced many troubles, a majority of them dealing with inflation and hyperinflation. Over the course of this time, the Brazilian currency changed so many times because as inflation grew, the current currency would become essentially useless. It did not make sense when, for example, you would need to pay 1000 dollars for a loaf of bread. As the currency would become less effective, a new one would be created to take its place. Changing the monetary unit and name during economic reforms is a way for government propaganda to signal that “things will be different now,” and “it will work this time around.” One semi-official slogan was “Tem que dar certo!”  which translates to “it has to work!” This was created during the Plano Cruzado in 1986, where the cruzado was created, (1 cruzado = 1000 cruzeiros, the former unit) (History Stack Exchange, 2017). The overall trend for the Brazilian currency has been very downhill, however in recent years the currency has begun to moderately stabilize. In 2011 after a dramatic decrease in trade with China, the Real dropped in value and by 2017 the Brazilian GDP had dropped by 9%.

The first official currency in Brazil was the Real which was denominated as R$ (Online Coin Club, 2018). The name “Real” came from the Portuguese word meaning “royal.” It is also interesting to note that in Brazilian currency, the dollar sign uses two-vertical strikes instead of just one. When Brazil became independent in 1822, the Real was kept as the official currency. However, as inflation began to increase the government introduced different ways to write currency on their banks notes (Continental Staff, 2015). A banknote valued at under 1,000 reis was written as R$ 999 and any currency over 1,000 reis was written was R$ 10$000 for 10,000 reis. By the 1890s, the currency had hit an all-time high inflation of 41%. This created the need for one million-dollar banknotes and were written by placing a “:” after the million-dollar digit. For example, 10,000,000 would be written as 10:000$000. The real remained in circulation for the next 50 years and through this time still faced increase inflation of about 6% per year. By 1942 the Real was finally discontinued and the “Cruzeiro” was introduced with an exchange of 1$000 reis to 1 cruzeiro.

The Cruzeiro was introduced in 1942 and had two distinct currencies during its time in circulation. The name “cruzeiro” refers to the constellation of the Southern Cross. This is known in Brazil as the “Cruzeiro do Sul” (Faber, 2015)The Southern Cross can only be seen in the southern hemisphere and it’s a large part of Brazilian culture. The Southern Cross can be seen on numerous State flags, an airline company called Cruzeiro do Sul and has a Brazilian soccer team named after it, called the Cruzerio Esporte Clube. The first cruzeiro had the symbol of Cr$ or ₢. The “₢” is special because it is the only symbol created for Brazilian currency. The first cruzeiro was used between 1942 and 1967. In 1967, after severe inflation the first cruzeiro was replaced by the “cruzeiro novo” which meant “new cruzeiro.” 1$000 cruzeiro where equal to 1 cruzeiro novo (Banco Central Do Brasil, 2018). The “₢” was also dropped during this time because the symbol was rare and most typewriters at the time did not include the monetary symbol, therefore the cruzeiro novo used the symbol of NCr$.

In 1986 the Brazilian government switched the currency again from the cruzeiro novo to the Cruzado which was written as Cz$. Similar with the currencies that came from before it, 1$000 cruzeiro novo was equal to 1 Cruzado. In 1979 the Second Oil Crisis occurred and this created a major issue for Brazil. Brazil is a major importer of crude oil and as the price for crude oil doubled, the Brazilian government (out of desperation), began devaluing its own currency in order to generate stability. It was thought that a lower value of the Brazilian Cruzado, would increase for foreign trade and help stabilize the economy. By February 1983, the Brazilian government had already devalued its currency 8 times with the largest being 2.4%. At the end of February, the Brazilian government announced it would devalue its currency by 30%. By this point interest rates soared between 250% up to 350% (Hoge, 1983).

On January 15th, 1989, the second shortest lived Brazilian currency was introduced. With the failed attempts of the Cruzado, the Cruzado Novo was brought to light. The Cruzado Novo had an exchange of 1$000 Cruzado to 1 Cruzado Novo. The Cruzado Novo was written as NCz$. Essentially, all the that Brazilian mint did was stamp the old currency of the Cruzado (Farlex Financial Dictionary, 2009). For example, a 1$000 Cruzado note would have been stamped with a NCz$ 1-dollar stamp, which effectively made it 1 dollar. However, the Cruzado Novo did not last long and on March 15th, 1990 the Brazilian government chose to go back to using the Cruzeiro as its currency. The Cruzado Novo was transferred back into Cruzeiro at par value. The currency went back to being written as Cr$. As with all the currencies that came before it, the third installment of the Cruzeiro was created to help control inflation. However, this attempt again was unsuccessful which lead to the generation of another currency.

By 1993, the third Cruzeiro was replaced by the Cruzeiro Real, shortest with a lifespan with only 11 months in circulation from August 1st, 1993 to June 30, 1994. The exchange was 1$000 Cruzeiro to 1 Cruzeiro Real which was written as CR$. The difference between the third Cruzeiro and the Cruzeiro Real is that the “r” is capitalized when using the real.

Brazilians understood there were many issues affecting the economy and their currency as a whole. When Itamar Franco became the President of Brazil, he made a large effort to figure out a way to control the inflation and help bring peace to the people of Brazil. President Franco brought on his Minister of Finance, Fernando Henrique Cardoso to help figure out what they could do – the Plano Real was born. What was then created became one of the most sophisticated pieces of the plan and the Unidade Real de Valor (URV)translated to “Real Value Unit” was created. The purpose of the URV was to create a parallel monetary value to the current Cruzeiro Real (which at the time was inflating at a rate of 1,200% per year). The URV was set to be valued at $1 USD however any payments that needed to be made would have to made in the currency Cruzeiro Real. The sole purpose of the URV was to help break the psychological notion that Brazilians’ felt that their currency was useless. All bills and other payments would be shown in both URV and CR. This helped Brazilians understand that cost assessment and essentially not “jumping the gun,” and assuming that the currency would inflate helped bring stability.

On July 1st, 1994 the Brazilian Real was brought into circulation and was written as R$. The exchange was R$ 1 = $1 URV = CR$ 2$750. As of April, 2016, the Brazilian Real is the 19th most traded currency in the world (Bank for International Settlements, 2016). An interesting fact to note is with all previous currency changes in the country’s history, this reform made the new real equal to 2.75 × 10 to the power of 18 (2.75 quintillions) of Brazil’s original “reis” (Global Exchange, 2018) .As the new Brazilian Real was introduced the URV was removed from practise. Brazil had successfully turned its economy around using fake money. As the Real was traded on the international market, it took some time for it grow. As it was introduced to be on par with the USD, it began by slowly devaluing for 2 years until it sprang back. As of today, the new Brazilian Real has brought almost 20 million people out of poverty (Joffe-Walt, 2010). The overall trend of the current Brazilian Real has changed over its inception in 1994. The currency did unfortunately inflate up to around R$ 4.09 to $1 USD, however it has fallen to R$ 3.34 to $1 USD as of today April 4th, 2018 (Market Watch, 2018). Between 2014 and 2015 the currency fell sharply due to a deep recession within the country. However, over the last few years the Real has been able to rebound by about 23% (Lifatov, 2017). There is hope that the trend between the USD and the Brazilian Real will continue to decrease, but as of right now there are too many macroeconomic disruptions within the country to make a clear decision.

Arguments supporting trouble ahead?

Imposed taxes from the United States on Iron can cause huge problems to Brazil, because at the moment, the country’s largest buyer of the product is the US (AROUND 40% of iron exports goes to the United States). This will affect at least ⅓ of the steelworks, making the recovery of the economy harder. In 2017, the harvest for agricultural products was great. This helped to increase the supply of products in the food market. This caused a decrease in the overall food prices, and consequently, the overall inflation rate for that year. However, with the possibility of the La Nina effect happening this year, the harvest doesn’t have a positive outlook for 2018.

Unemployment rate continues dropping, mainly because more people stopped searching for jobs, fourteen million people remain unemployed, which makes Brazil a country with one of the biggest gaps between the wealthy and poor (Cascione, 2017). Although the recession is over, only moderate recovery is expected, public finances are dragging on growth, and increase the risk of further credit downgrade, the uncertainty ahead of the elections in October 2018, has left the investment sector hanging. The public finance deteriorated further in the past year, and the primary deficit in October 2017 was 2.9% of the GDP, nominal public deficit increased from 8.8% to 9.3% of the GDP. Uncertainty of the upcoming election, President Temer who has been in power since Dilma Rousseff’s removal in August 2016, has gone from crises to crises, the president’s biggest problem is the huge corruption scandal, more and more politicians are getting implicated and the accusations against President Temer is also increasing. The elections result will influence the speed at which important reforms and spending cuts are implemented, this will affect the economic growth in the coming years.

Argument supporting Recovery

According to IBGE Statistics agency, Brazil is experiencing an historically low inflation period, the 1st nine months of 2017, inflation was 1.78%, the lowest in 19 years, in September 2016, the inflation was 2.54%, this allows the Brazilian economy to slowly emerge from its worst recession (Fresh Plaza, 2017). The weak currency is helping Brazilian exporters in sectors such as agricultural commodities, processed foods, processed meat and mineral commodities, this results in some of the largest Brazilian multinationals see increase in profitability in the foreign market, because investors and business leaders are taking advantage of Brazil’s weak currency (Pedersen and Partners, 2015). Increased household spending has been key in getting Brazil out of recession, in 2017, gross domestic product grew 1.4% from the third quarter in 2016, this is a positive sign of Brazil slowly getting out of the recession, as customer spending is also growing, a forecast shows that Brazil’s GDP would grow 0.7% in 2017 and 2.3% in 2018, and if these expectations hold true, the Brazilian economy is set to outpace Mexico’s economy for the first time in five years (Federowski, 2017). Growth forecast for 2017 raised from 0.5% to 1%, growth in 2017 was driven by a robust export sector and a stronger than expected recovery of private consumption, the decline in interest rate is also helping by reigniting demand for customer credit.

How likely is high inflation?

Brazil, like most South American countries has had a volatile past in terms of economic measures. Inflation in Brazil has the tendency to be ever-changing and drastically different, even reaching 6821.31% in April of 1990. Needless to say, inflation is a very real issue in Brazil (Brazil Inflation Rate, 2018). This section attempts to explain recent happenings in Brazil’s politics and how they have affected inflation, five reasons explaining why inflation has been so volatile in the country and the current way of controlling inflation as part of the monetary policy, inflation targeting.

Brazil is the largest economy in South America and is a nation rich in natural resources, land and corruption. The growth rate dipped from 7.5% in 2010 to -3.6% in 2016. Brazil experiences stagflation, a situation where high inflation rates are combined with low or declining economic growth, which leads to higher unemployment (Amadeo, 2018).

The Story of Lula and Rousseff

In 2002, Luiz Inácio Lula da Silva was elected as President and he played a critical role in strengthening the Brazilian economy. This was done through making economic growth the top priority and using tools such as increased government spending, lowering unemployment and developing existing national resources such as metals and oil. Lula employed such smart financial tools, that Brazil managed to avoid the crisis of 2008 altogether by keeping mortgages within banks instead of selling them off to third parties. In 2007, Brazilian economic growth sat at 5.4%, inflation was low at 3.6%. This cause Brazilians to spend more money and the economy boomed, causing speculation that Brazil was the strongest market amongst the four BRIC countries. Overall, things seemed great during Lula’s long reign of two terms however, there was criticism that the wealthy benefitted the most, which could have some truth as Lula was eventually arrested and charged in 2018 for accepting bribes for gifting construction contracts (Amadeo, 2018).

In 2010, Dilma Rousseff became President and she took measures that triggered inflation. Firstly, Rousseff increased public spending, raised minimum wage and forced banks controlled by the state to increase lending. Simultaneously, the Central Bank lowered interest rates from 11.5% to 7.25%. The resulting inflation was due to sales tax and lower prices for food, gas and public transit. Due to the excessive price control, state-run firms like Petrobras suffered. Business stopped investing in Brazil due the high control and the government intervened in deciding public sector contracts like railways, roads and banking industry (Amadeo, 2018).

The drastic expansionary fiscal and monetary policy under Rousseff’s government lead to inflation rising even higher than the newly increased wages, which meant that instead of spending money like the government anticipated, consumers began saving money (Amadeo, 2018).

Another powerful hit to the economy came in the form of a strengthening US Dollar. With Dollar value rising, Oil prices declined, and because Brazil’s primary export is oil, exports dropped causing increased unemployment and reduced production. The strengthened dollar also meant that the Reais was worth less, causing imports to rise in price. With import prices rising and export prices dropping, Brazil’s net export adversely affected the country’s GDP (Amadeo, 2018).

High inflation is a problem; however, the goal of most Central Banks is to maintain price stability, which would be possible if inflation stayed constant, even at a higher number. However, constantly fluctuating rates are harder to fix.

The Main factors contributing to Brazil’s Inflation volatility

  1. Brazil is a large but closed economy. With imports and exports only making up 20.1% of the CPI basket as of 2015, meaning that the economy responds strongly to internal supply shocks. Food prices are especially indicative of this. In 2017, Brazil’s Safrinha harvest of corn was bountiful, which guaranteed low prices at home due to excess supply (Ikeda, 2017). However, this can change quickly as Brazil faces unpredictable external factors such as La Nina and El Nino, which are phases in the weather that cool or warm up ocean temperatures, causing natural disasters as well as affecting temperatures (National Ocean Service, 2018).
  2. Brazil is a low savings economy with large amounts of commodity exports. The amount was 47.4% of commodities in the export basket as of 2015. Due to this large percentage, Brazil’s GDP is greatly affected by internationally set commodity prices. If prices for oil or steel dropped, Brazil takes a huge hit, something that occurred in the past in 2016 when Iron Ore prices dropped by approximately 50% after reduced demand from China (Atlas Media, 2018).
  3. Regulated prices are another issue in Brazil that make monetary policy ineffective. 23.1% of the prices in the CPI basket are composed of contract or government “regulated” prices. These prices are not set based on a fixed, transparent formula, which means that sometimes the prices are not accurate to inflation rates. These prices are also used to make up shortcomings in tax revenues. Both these factors make 23.1% of the CPI basket respond lethargically to monetary policy.
  4. A large portion of credit in Brazil is subsidized, up to 49.2% in 2015. This credit is offered through government controlled channels and has some form of subsidy attached. Directed credit is less responsive to monetary policy.
  5. High amounts of corruption in Brazil has led to public distrust of the government and the government’s judgement, including in terms of economic policy.

Inflation Targeting

Inflation Targeting is a Monetary policy approach that tries to establish a specific inflation rate for a country in a financial period. Inflation Targeting has a few components which are detailed below. Brazil introduced inflation targeting four years after the introduction of the Plano Real. In 1999, the highest inflation target was announced at 8% and has since fluctuated at 3.25% to 5.5%. In recent years the target has been hovering around 4.5% (2005 – 2012) (Novais, 2011).

The 5 main components to using inflation targeting in a countries strategy.

  1. A medium-term, numerical value is announced
  2. A commitment is made to keeping price levels stable, this becomes the main monetary policy goal, to which all other goals are subordinated to.
  3. A strategy that considers many variables, not only monetary aggregates is used for deciding policy instruments.
  4. Open communication with the public regarding objectives of the Central Bank.
  5. Increased accountability for the Central Bank in attaining its inflation objectives.

Current Situation: 2017 and Onwards

In 2017 inflation was 2.95%, compared to the 6.29% from 2016 and 10.67% in 2015. This suggest that the country is in fact improving in terms of keeping inflation regulated, however, 2017 is reported to have been a fluke year with more volatility coming up in 2018. The upcoming elections in Brazil are predicted to cause much uncertainty in the country’s economic landscape as the economy will be vulnerable to political cycles depending on who is elected. The current front runner, Jair Bolsonaro, is a militarist who avoids questions regarding economic policy.

Recommendations

In terms of Monetary policy, the greatest recommendation is not do any action. The situation in Brazil is so ingrained with political problems, that is starting to affect the economy of the country. Currently, making any economic changes will not provide any benefits to the population, instead, it will only cause more issues. One example of the possible changes that could be implemented by the Central Bank is to increase the interest rate. However, when compared with more stable countries, such as Canada or United States, which have low interest rates, are more stable.

The interest rate change would cause an increase in the overall prices, which is considerably high the way it is due to high inflation. Therefore, we recommend the Central bank to not take any measures at the moment and wait until the political issues settle.

The second recommendation is regarding the exchange rate. In light of the political and economic unstable scenario, the rate is devalued, and extremely volatile. The fact that Brazil has a considered low rate is beneficial for the country’s exports. However, the extreme volatility is not healthy for the business and the international trade, making the country an unsafe country to invest and create business. Therefore, creating measures that maintain the interest rate low, but keeping it within a rage would help the country to get out of their situation.

One of the main issues with the recent political measures taken is the excessive focus on consumption. As mentioned before, in several moments, the Brazilian government adopted measures that the main focus is to increase household expenditure. Increase in consumption it’s a measure that can only help the country on a short term. Instead, the country should adopt policies that focus more on production. By doing so, it has the potential to increase the overall employment rate, as it will be required to the business to produce more goods and services, increasing the demand for labour. As a consequence of that, the national income will increase and will lead to a greater household spending. This is a longer process, but has more effect on the long term, instead of consumption focus.

Overall, Brazil is in a very complicated situation. There are several measures that can be taken to get out of the current crisis. However, the measures that can be taken by the Central Bank are minimal. Given the fact that the problems are tied with the political instability, and as a consequence, damages the economy, there is not much to do. The best monetary policy it can be adopted at the moment is to maintain the interest rate, and the exchange rate as it is, without extreme changes. Once the country solves the political problems, a new set of possibilities will open for Brazil, but this won’t happen in any near future.

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