Thursday, March 19, 2009

The Failure of Inflation Targeting in Brazil

All around the world, different flavors of inflation targeting regimes suddenly became irrelevant for monetary policy and have undeniably contributed to cycles of credit expansion that disregarded financial stability, being therefore one of the factors behind the current financial crisis. Economists should recognize that regimes based on inflation expectations anchors and on nominal interest rates as monetary policy instrument have not promoted financial stability. Narrow focus on CPI inflation as a monetary policy target should be abandoned (I'll return to this point in a future post).

Consider for now the case of inflation targeting in Brazil. I worked as an economist with the Central Bank of Brazil from 1999 to 2001 and helped to implement the new-Keynesian inflation targeting framework currently in place in that country. Despite being considered a success by some economists when judged against extremely poor preexisting standards, the truth is that the system has never worked well.

Sachsida for example wrote a post (in Portuguese) that explains how inflation targeting failed to anchor inflationary expectations and may even have been responsible for the exchange rate run-up of 2002 (my translation):

The goal of this post is to question the current interpretation regarding the success of the inflation targeting regime in Brazil. I'd like to know how it is that a system that SYSTEMATICALLY fails to reach its targets can be considered a success. In its 10 years of existence, the inflation targeting regime was incapable to fulfill its targets in almost half of the years; and in the other half, nothing guarantees that the inflation targeting regime was responsible for price stability.

The exchange rate run-up that Sachsida refers to in his post is seen in this graph:
Run-ups like the one above are proof that monetary policy regimes based on nominal interest rate instruments, as exemplified by new-Keynesian inflation targeting regimes, are not able to stabilize prices of important financial assets, even when CPI inflation is (barely) under control, creating thus financial instability and eventually financial crises. The phenomenon is not exclusive of Brazil: it may explain, at least partially, most financial crises that we've seen around the world in recent history.

1 comment:

Blog do Adolfo said...

Hello Pedro,

Would be great to listen more about your experience during the implementation of the inflation target in Brazil.

Adolfo