# targeting regime retained credibility.

After peaking in early 2016 following the realignment of administered prices, inflation gradually moderated, and the BCB began an extended period of interest rate easing late in the year. By the end of 2017, inflation was slightly below the 3 percent lower bound of the target band, largely due to food price deflation that in turn reflected very strong agricultural production. Five-year-ahead inflation expectations continued to moderate during this period.

The behavior of inflation expectations in Brazil has been broadly consistent with the estimated sensitivity of long-term inflation expectations to shocks. Following a large initial drop in the sensitivity of expectations to shocks after the introduction of the inflation targeting regime in 1999, sensitivity has been more or less constant, suggesting that the inflation targeting regime has been successful in anchoring expectations. Yet the sensitivity to shocks is still higher than in some other inflation targeting emerging market and developing economies (EMDEs). A deterioration of fiscal balances could have impeded the anchoring of inflation expectations (Cerisola and Gelos 2009; de Mendonça and Veiga 2014). An additional factor may have been that central bank independence was less well established in Brazil than in other countries (Cortes and Paiva 2017; Minella et al. 2003).

Lessons learned. Brazil’s experience with inflation targeting offers two key lessons. First, long-term inflation expectations can remain stable during sharp fluctuations in actual inflation even in the absence of typical elements of inflation targeting regimes elsewhere (for example, the central bank having sole power to set inflation targets, fixed-term appointment of central bank governors, and use of a narrow inflation target band). Further, inflation expectations in Brazil have been stable despite periodic questions about the credibility of the inflation targeting regime arising from its unique institutional arrangements (IMF 2015). However, some of the specifics of the regime (that is, a wide target band and use of only December data for measuring results) have arguably made formal compliance with targets easier than in most other inflation targeting countries.

Second, fiscal policy can be a key factor in determining the outcome of inflation targeting and controlling inflation expectations (Cerisola and Gelos 2009; de Mendonça and Veiga 2014). For instance, during the 2001-03 currency crisis, Brazil avoided a prolonged growth contraction thanks to the fiscal adjustments put in place in the late 1990s. These measures lent support to the inflation targets and the BCB’s well-articulated strategy for reverting inflation to target levels (Giavazzi, Goldfajn, and Herrera 2005). At the same time, the structure of public debt in Brazil at the time—a large share of debt was short term or denominated in foreign currency—was a constraint on the central bank’s ability to target inflation freely, since interest rate hikes abroad had a significant adverse impact on debt service obligations. Similarly, the high level of foreign currency–denominated debt may have also dissuaded the central bank from allowing the exchange rate to float freely, despite the stated commitment to floating (López Vicente and Serena Garralda 2014). Over time, the structure of public debt has changed, and the vast majority of domestic debt is now issued domestically. However, the stock of debt has risen rapidly in recent years.

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