Henrique Meirelles: Challenges for monetary policy - Brazil and the
international context
Speech by Mr Henrique Meirelles, Governor of the Central Bank of Brazil, at the Conference
"The Impact of Brazil on the Global Scenario", São Paulo, 10 July 2008.
* * *
In mature economies, the years from the beginning of the 1990s to mid-2007 were
characterized by low GDP volatility and low inflation, circumstances that led prominent
economists to name the period as the era of the "great moderation". That environment
resulted from better monetary policy, a fact that translated into credibility gains for central
banks, globalization and advances in productivity linked to information technology
developments. At the time there was a substantial consensus that the emergence of Asia,
particularly of China and India, would contribute to keep global inflation permanently under
control. Thanks to cheap labor and the intensive use of new technologies on the production
process, China - and to a lesser extent India - exported deflation (or at least disinflation) to
the world economy through a consistent decrease in their export prices.
There is now growing evidence that this era might have came to an end with the unbalances
between the expansion of global demand and supply. Moreover, there are also signs of
increasing labor costs in China, due to both changes in labor legislation and increasing
shortages of specialized workforce.
In the benign environment that prevailed through mid-2007, central banks of mature
economies engaged in neutral or even expansionary monetary policies for relatively long
periods. Under these circumstances, the traditional pro-cyclicality of credit emerged once
again, fuelling asset price inflation (particularly real estate prices in certain regions of the US
and Europe) rather than consumer price inflation.
In the past twelve months the scenario changed radically: a severe financial crisis, stemming
from the US real estate sector, hit mature economies in general, whereas demand pressures
over the availability of limited production factors led to mounting inflation in a global scale.
Thus, central banks currently face a much more complex and challenging environment than
during the years of the great moderation. Monetary responses have been initially diverse due
to the nature of the problems that surfaced, but the priority on the need to preserve price
stability prevails.
Due to both increases in raw material prices and demand pressures, inflation accelerated
sharply around the globe. In mature economies in general, marked by broader levels of idle
capacity, higher commodity prices probably explain the bulk of the inflation upsurge. In
emerging countries, including Brazil, domestic demand pressures have had a relatively more
important role in stoking mounting inflation pressures. As a matter of fact, strong domestic
demand in these economies created conditions that enabled initially isolated price pressures
to become more widespread. Not surprisingly, monetary policy is currently more and more
focused in moderating the pace of demand expansion and containing inflation pressures in
the majority of the emerging world.
The stance of each central bank will respect local economic conditions, but the absence of a
coordinated action on a global scale cannot be an excuse for a lenient stance on the
domestic inflation front. More specifically, the Brazilian Central Bank has not waited and will
not wait for other central banks to act in order to start fighting domestic inflationary
pressures. Not acting promptly would enable initial specific price pressures to contaminate
inflation dynamics permanently, due to deteriorated inflation expectations of both price and
wage setters.
In the beginning of 2008, the Brazilian Central Bank stressed in its regular publications that
inflation risks had mounted, a fact that could require an adjustment in its monetary stance.
This assessment surprised many analysts that expected inflationary pressures to be
contained by a spontaneous slowdown in economic activity, an expectation that did not
materialize. Other analysts seemed to believe that increases in commodity prices were
temporary and that the Central Bank should wait for the complete materialization of
inflationary pressures to finally start acting. It is clear now that this complacent approach
would have had deleterious and long-lasting consequences for the economy.
As repeatedly stressed by the Central Bank, the balance of risks for inflation became less
favorable, not only due to external factors, but also - and more importantly - due to domestic
factors. On the external front, the contribution of imports to sustain a benign inflation scenario
has become less effective. On the domestic front, fast aggregate demand growth continues
to be an important source of inflation risks, particularly amid increasing evidence of limits to
the expansion of supply - and despite the robust behavior of fixed-capital investment.
Moreover, it is clearer now that additional increases in aggregate supply depend on
increases in the investment rate of the economy, a process that requires time. In this context,
the Central Bank evaluates that the consistent reduction of the unbalances between the pace
of expansion of supply and demand continues to be crucial in the design of monetary policy.
The Brazilian Central Bank adopts a strategy aimed at avoiding inflation volatility. This
approach takes into account the time lags in the transmission mechanism and has proved to
be the most adequate to deal with uncertainties intrinsic in the process of monetary policy
formulation and implementation. Thus the importance of developing an appropriate analytical
framework for monetary policy, including forecasts and the balance of risks to inflation, as
well as the preemptive stance in the decision-making process of the Monetary Policy
Committee.
In the current circumstances, there is a potential risk that economic agents start to attribute a
higher probability that inflation increases will become persistent, a fact that would reduce the
effectiveness of monetary policy. The Central Bank stresses that the performance of
monetary policy tends to be more effective when the deterioration of inflation dynamics is in
the early stages, rather than when it is more established. Thus, monetary policy should
respond immediately in order to avoid that initially restricted inflation pressures translate into
an enduring deterioration in inflation expectations.
Recent decisions of the Brazilian Central Bank should be understood in that context. Their
effects over activity and inflation - potentially helped by some liquidity tightening in progress
since the first months of the year - are cumulative and will undoubtedly produce effects in
the coming quarters.
International evidence, as well as the Brazilian experience under inflation-targeting, shows
that there are no advantages of sustaining high inflation rates for long periods. On the
contrary, high inflation rates lead to higher risk premia, to shorter planning horizons and
consequently to lower potential growth of the economy. Its most harmful outcome is the
deterioration in income distribution, as low-income brackets are harder hit by the negative
effect of inflation on their purchasing power. It is now clearer than ever that fighting inflation
generates benefits in terms of decreasing poverty and reducing social inequalities. Thus, the
Brazilian Central Bank has acted and will continue to act in order to bring inflation back to the
midpoint target of 4.5% promptly, that is, during the course of 2009. This stance is designed
to avoid the consolidation of a negative inflationary environment, in which monetary policy
would lose efficiency.
It should be clear to the public that the Brazilian Central Bank will not have a complacent
approach regarding inflation. The Bank is committed to act in order to bring inflation to the
midpoint target during 2009. This is the approach that minimizes costs for economic activity
and for the society at large, contributing to consolidate a sound, efficient, and fair economic
structure. Thanks for your attention!