Paulo Vieira da Cunha Deputy Governor · Paulo Vieira da Cunha Deputy Governor Presented at the...

INFLATION TARGETING: BRAZIL’S EXPERIENCE

Paulo Vieira da Cunha Deputy Governor

Presented at the High-Level Regional Seminar on Inflation Targeting Hosted by the International Monetary Fund and Bank Al-Maghrib Rabat, Morocco─April 4, 2007

The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper.

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BAM/IMF April, 2007 1

Inflation Targeting: Brazil’s ExperienceSeminar on Inflation Targeting

Bank Al MaghribRabat, Morocco April 4, 2007

Paulo Vieira da CunhaDeputy Governor


Outline

I. OverviewII. Institutional StructureIII. Issues

A. Shocks & ExpectationsB. Increasing PredictabilityC. Reducing External VulnerabilityD. Reducing Fiscal Vulnerability


I. Overview: Inflation Targeting Has Worked


History

• INFLATION TARGETING was introduced in June 1999 at a time of great macroeconomic uncertainty — but of low inflation

• It followed critical economic reforms

– Fiscal Responsibility Law

– Social Security Reform (partial)

– Privatization of SOE’s

– Trade and Capital Account Liberalization

– Restructuring and Recapitalization of Private Banks (PROER)

– Closure and/or Divestiture of Public Banks (PROES)


1999: The New Macroeconomic Regime

Floating Exchange

Rate

Inflation Targeting

Solid Fiscal Anchor


Targets vs. Consumer Inflation%

p.a

.

0

3

6

9

12

15

18

Market Expectation

Feb 073.02

99 00 01 02 03 04 05 06Jan07

Mar08


Volatility of Inflation, GDP & Policy Rate

PeriodMean S.D.

Selic (Policy) RateInflation GDP

C.V. Mean S.D. C.V. Mean S.D. C.V.

Prior to IT4T94 – 2T99

3T99 – 4T06IT

3T99 – 4T06IT (excluding external shocks: 3T01 a 2T03)

10,4 9,9 95% 2,0 6,3 311% 35,4 14,1 40%

7,5 5,6 74% 2,5 3,5 139% 18,4 2,9 16%

6,0 3,3 55% 3,2 3,1 96% 17,5 2,2 12%

3T03 – 4T06IT (post external shocks)

5,4 2,3 42% 3,3 3,0 90% 17,4 2,5 14%


Predictability of Monetary Policy

Dec01

Apr02

Aug02

Dec02

Apr03

Aug03

Dec03

Apr04

Aug04

Dec04

Apr05

Aug05

Dec05

Apr06

Aug06

Mar07

decision –expectation (t-1)

decision –expectation (t-3)

-3-2-1012345678

Shaded areas: cycles of rate hikes


SELIC (Policy) Rate%

10

20

30

40

96 97 98 99 00 01 02 03 04 05 06 07

Average value prior to IT regime

Average value during IT regime


Real Income & Inflation “Surprises”3

mom

ovav

g R

$

IPC

A >

ex

pect

atio

nsIP

CA

<

expe

ctat

ions

IPCA (–) 12mo forward IPCAexp

Real income (IPCA deflator)

960

981

1002

1023

1044

1065

1086

1107

1128

1149

1170

May02

Dec02

Jul03

Feb04

Sep04

Apr05

Nov05

Jun06

Jan07

-5

-3

-1

1

3

5

7

9

11

13


Credit to the Private Sector vs. Inflation%

p.a

.

% o

f GD

P

Total Credit/GDP

Market Expectationsfor Inflation

12 Months Ahead

4

5

6

7

8

9

10

11

12

13

Jan02

Jul02

Jan03

Jul03

Jan04

Jul04

Jan05

Jul05

Jan06

Jul06

Jan07

22

26

30

34

% p

.a.

Day

s

CreditAverage Tenure

4

5

6

7

8

9

10

11

12

13

Jan02

Jul02

Jan03

Jul03

Jan04

Jul04

Jan05

Jul05

Jan06

Jul06

Jan07

210

225

240

255

270

285

300

Market Expectationsfor Inflation

12 Months Ahead


Risk and Investment19

90=1

00

Bas

is p

oint

s

EMBI+ Br (Q-2)(RHS)

Investment(LHS)

4Q06

108

113

118

123

128

133

138

143

1Q00

1Q01

1Q02

1Q03

1Q04

1Q05

1Q06

2Q07

200

500

800

1100

1400

1700

2000


Stock Market (Bovespa) Capitalization

0

100

200

300

400

500

600

700

800Ja

n/19

97

Jan/

1998

Jan/

1999

Jan/

2000

Jan/

2001

Jan/

2002

Jan/

2003

Jan/

2004

Jan/

2005

Jan/

2006

Jan/

2007

US$

bill

ion

0%

10%

20%

30%

40%

50%

60%

70%

80%

% of G

DP

Market capitalization - US$ billions Markets capitalization (% of GDP)


GDP Growths.

a.,

1990

= 1

00

120

124

128

132

136

140

144

148

152

156

160

1Q99

1Q00

1Q01

1Q02

1Q04

1Q05

1Q06

Average Growth1999-2003: 1.8%

Average Growth2004-2007: 3.7%

1T02

1Q07

4Q07

2007 Projection: 4.1%


Target & Model-Generated Forecasts

1

1

1

1

Target“Market” Scenario“Reference” Scenario

%

2

3

4

5

6

7

8

9

Jan06

Jun Nov Apr07

Sep Feb08

Jul Dec06 06 07 08 08

IPCA Inflation: 12mo forward

Forecasts


Policy Rate: Expectations 6-mo Forward

11.6

12.2

12.8

13.4

14.0

14.6

15.2

Mar06

Apr06

May06

Jun06

Jul06

Aug06

Sep06

Oct06

Nov06

Dec06

Jan07

Feb07

Mar07

% p

.a.


II. Institutional Structure


Key Parameters

National Monetary Council sets the Inflation Target (Headline CPI-IPCA)

June of each year for 2 years ahead

Central Bank is charged with its attainment

Band of ± 2% w/o escape clause

The Monetary Policy Committee (COPOM) sets

the policy interest rate (SELIC)

The policy rate affects inflation expectations and actual inflation, with a lag


Institutional Structure of IT

National Monetary Council

President of the

Republic

Board of DirectorsAlso sit as members of

Monetary Policy CommitteeCOPOM

• Policy Targets Agreement

• 2 yr Rolling Forward Targets

• President Appoints Members of Monetary Council

• President Nominates Governor and Board of Directors

PublicMarkets

Senate

• Confirms Presidential Appointments

• Committee hearings

Governor


Inflation Targets & Bands: 2006

0123456789

10R

eino

Uni

doC

anad

áIs

rael

Nov

a Ze

lând

iaSu

écia

Nor

uega

Aus

trál

iaIs

lând

iaC

oréi

a do

Sul

Eslo

váqu

iaTa

ilând

iaPe

ruPo

lôni

aC

hile

Rep

Tch

eca

Méx

ico

Hun

gria

Col

ômbi

aFi

lipin

asÁ

fric

a do

Sul

Bra

sil

Rom

ênia

Turq

uia

Indo

nési

a

Midpoint of target range

% a

.a.

Advanced economies Emerging market economies


III. Issues


A. Shocks & Expectations


Price, Supply & Political Shocks: 2001-02

• Domestic & external shocks:– Energy Crisis– Argentina-I– Argentina-II– Brazil’s “fear of the left” political & risk aversion crisis

• Sudden stop in external capital flows and aversion to claims denominated in local currency

• Increase in country risk• Exchange rate depreciation• Pass-through to inflation (aggravated by backward-looking

price setting rules for administered & regulated prices)• Inflation at 7.7% in 2001 and 12.5% in 2002, missing the target

ranges (4% + 2% in 2001 and 3.5% + 2% in 2002).


Political Shock: 2002

2,37

8

2,42

0

2,34

7

2,32

0

2,48

0 2,71

4

2,93

5

3,11

0 3,34

2 3,80

6

500

900

1300

1700

2100

jan-02 fev-02 mar-02 abr-02 mai-02 jun-02 jul-02 ago-02 set-02 out-02

Spre

ad o

ver U

S-TS

Y

2,000

2,500

3,000

3,500

4,000

BR

L/U

SD R

ateBRL/USD

BR C-BondBR2040 Bond

Devaluation of 131%


Expectations Deficit: 2002Difference between measured expectations and the mid-point of the Inflation Target for the yearBased on the median of the sample of market expectations for year-end IPCA inflation

Target: 3.50%E (X): 12.52%Actual:12.53%

0

200

400

600

800

1000

jan-02

fev-02

mar-02

abr-02

mai-02

jun-02

jul-02

jul-02

ago-02

set-02

out-02

nov-02

dez-02

2002

2003

2004


Rebuilding Confidence: 2003-2004

• 2002: Inflation exceeded the target by a large margin• The disinflation trajectory lost credibility• Sharp increase in inflation expectations - medium term

• 2003: Central Bank announced an adjusted target trajectory• The objective was to regain the lead over expectations,

smoothing the cost of disinflation: • Adjusted targets trajectory proposed in 2003:• 2003 8.5% ± 2.5%• 2004 5.5% ± 2.5%


IPCA Inflation: 2002- 2004

YoY % change based on the 12momovavg

4,0%

8,0%

12,0%

16,0%

20,0%

jan/02 abr/02 jul/02 out/02 jan/03 abr/03 jul/03 out/03 jan/04 abr/04 jul/04 out/04

Tradables

Headline

Non-Tradables

Core



• In Feb/2003 the COPOM increased the policy rate to 26.50% and kept it at that level until May/2003

• Reaffirmed commitment to fiscal responsibility• Increase in the consolidated primary surplus:

– 4.25% of GDP in 2003– 4.50% of GDP in 2004

• Sharp FX depreciation from 1999 to 2002 produced a major external adjustment, with a significant increase in exports

• Benign external scenario contributed to exports surge and exchange rate appreciation


Policy Rate: 2002- 2004

set-0416,25

fev-0326,50

0,00

5,00

10,00

15,00

20,00

25,00

30,00

jan-02

abr-02

jul-02

out-02

jan-03

abr-03

jul-03

out-03

jan-04

abr-04

jul-04

out-04



• Inflation fell to 9.3% in 2003, from 12.5% in 2002• It fell to 7.6% in 2004

• Successful disinflation allowed a return to the original targetsset for 2005-2007:– Target set in 2003:

2005 4.5% ± 2.5%– Target set in 2004:

2006 4.5% ± 2.0%– Target set in 2005:

2007 4.5% ± 2.0%


Expectations Deficit: 2003

0

75

150

225

300

375

450

jan-03

fev-03

mar-03

abr-03

mai-03

jun-03

jul-03

ago-03

set-03

out-03

nov-03

dez-03

2004

2003

2005

Difference between measured expectations and the mid-point of the Inflation Target for the yearBased on the median of the sample of market expectations for year-end IPCA inflation

Target: 8.50%E (X): 9.22%Actual: 9.30%


B. Increasing predictability


Consolidating the Regime: 2005-2006

• Rapid pace of economic recovery post-2003, led by a large surge in exports, fueled domestic demand and together the growth in external and domestic demand threatened the inflation target in 2005 — especially after a sudden expansion in fiscal outlays in Q4/2004

• Consequently, starting in Sep-2004 the COPOM started on a tightening cycle that was to last one full year to Sep-2005, with an accumulated increase in the policy rate of 375bp

• Expectations and eventually inflation adjusted to retake the path of the inflation target

• Inflation expectations for 2006 were contained and approached the target. At end 2005 expectations for the next two years werein line with the target


Inflation Expectations vs. TargetsExpectation

t+1Target

t+1Expectation

t+2Target

t+2

1999 7,0 6,0 4,0 4,0

2000 4,3 4,0 3,8 3,5

2001 4,8 3,5 4,0 3,25*

2002 11,0 4,0** 8,0 3,75**

2003 6,0 5,5 5,0 4,5

2004 5,7 4,5 5,0 4,5

2005 4,5 4,5 4,5 4,5

*CMN target: Jun/2001 (Resolução nº 2,842)** CMN target: Jun/2002 (Resolução n° 2,972)

2006 4,0 4,5 4,1 4,5


Expectations Deficit: 2005

0

40

80

120

160

200

jan-05

fev-05

mar-05

abr-05

mai-05

jun-05

jul-05

ago-05

set-05

out-05

nov-05

dez-05

2006

2005

2007

Difference between measured expectations and the mid-point of the Inflation Target for the yearBased on the median of the sample of market expectations for year-end IPCA inflation

Target: 4.50%E (X): 5.68%Actual: 5.69%


Policy Rate: 2005 - 2007

mar-0712,75

set-0519,75

0,00

5,00

10,00

15,00

20,00

25,00

30,00

jan-05

mar-05

mai-05

jul-05

set-05

nov-05

jan-06

mar-06

mai-06

jul-06

set-06

nov-06

jan-07

mar-07


Expectations Surplus: 2006Difference between measured expectations and the mid-point of the Inflation Target for the yearBased on the median of the sample of market expectations for year-end IPCA inflation

-160

-120

-80

-40

0

40

jan-06

fev-06

mar-06

abr-06

mai-06

jun-06

jul-06

jul-06

ago-06

set-06

out-06

nov-06

dez-06

2008

2007

2006 Target: 4.50%E (X): 3.11%Actual: 3.14%


Predictability of Monetary PolicyAverage Deviation: Actual vs. Expected Policy Rate Changes

p. p

.

0,10

1,06

0,130,06

Dec 01Sep 02

Oct 02May 03

Jun 03 Aug 04

Sep 04Aug 05

Sep 05Jan 07

Mean: 0,26

Lag: 1 month Lag: 3 months

0,23

0,0

0,2

0,4

0,6

0,8

1,0

1,2

0,20

3,59

0,69

0,25

Dec 01 Sep 02

Oct 02 May 03

Jun 03 Aug 04

Sep 04 Aug 05

Sep 05 Jan 07

Mean: 1,001,05

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0


Real Interest Rates

7,95

10

15

20

25

30

35

96 97 98 99 00 01 02 03 04 05 06Feb*

07

Avg 06/07:9,3%

Avg 96/99:18,5% Avg 04/05:

11,5%

Avg 00/03:15,0%

Rates for the 360d Fixed-to-Float Swap – BM&F


C. Reducing External Vulnerabilities


Trade Surplus

-20.

7

-21.

0

-20.

6

-25.

3

-33.

1

-50.

0

-53.

3

-59.

7

-57.

7

-49.

2

-55.

8

-55.

6

-47.

2

-48.

3

-62.

8

-73.

6

-91.

4

-107

.1

31.4

31.6

35.8

38.6

43.5

46.5

47.7

53.0

51.1

48.0

55.1

58.2

60.4 73

.1 96.5 11

8.3

137.

5

147.

3

-1.2

2.7

46.1

-120

-90

-60

-30

0

30

60

90

120

150

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007*

Expo

rts, I

mpo

rts (U

S$bi

llion

)

-10

0

10

20

30

40

50

Trade balance (US$billion)

Imports Exports Trade Balance


Trade Balance vs. Exchange Rate U

S$ b

n

BR

L$/U

S$

BRL/USD Rate

Trade Balance

10

15

20

25

30

35

40

45

Jan03

Jul03

Jan04

Jul04

Jan05

Jul05

Jan06

Jul06

Mar07

2,02,2

2,42,6

2,83,0

3,23,4

3,63,8

12mo forward expectations


Expectations: Trade & Current AccountU

S$ b

illio

n

Trade Balance Current Account

2005

2006

2007

-8

-4

0

4

8

12

16

Apr04

Aug04

Dec04

Apr05

Aug05

Dec05

Apr06

Oct06

18

22

26

30

34

38

42

46

50

Apr04

Jul04

Oct04

Jan05

Apr05

Jul05

Oct05

Jan06

Apr06

Jul06

Dec06

2005 2006

2007


Expectations: BRL/USD RateR

$/U

S$

2,0

2,2

2,4

2,6

2,8

3,0

3,2

Dec04

Jun05

Dec05

Jun06

Dec06

Jun07

Dec07

Jun 04

Dec 04

Jun 05

Dec 05 Jun 06 Dec 06


REER & Commodity Prices

Jun-

1994

= 1

00

1995

= 1

00

Real Effective Exchange Rate

Non-oil Commodity Price Index

78

93

108

123

138

153

Jan03

Jul03

Jan04

Jul04

Jan05

Jul05

Jan06

Jul06

Feb07

95

105

115

125

135

145

155

165


Buildup in Reserves

Jan 05US$ 54.0 bi

Jan 06US$ 56.9 bi

Mar 07*US$ 104.8 bi

US$

bill

ion

0112233445566778899

110

Jan03

Jun03

Nov03

Apr04

Sep04

Feb05

Jul05

Dec05

May06

Oct06

Mar07

*Mar 9


Reduced External LiabilitiesCumulative Reduction in FX-Linked Debt and BCB’s

Accumulated Acquisitions in the FX Market since 1Q05

US$

bill

ion

0

30

60

90

120

150

180

210

1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06

FX MarketFX-Linked Domestic DebtSwapExternal Debt (Treasury + BCB)

55.8

100.7

26.7

9.1

Total = $192.3bn


Declining External Debt

Total External Debt/GDP Reserves/Short-Term External Debt by Residual Maturity

Tota

l Ext

erna

l Deb

t/ G

DP

(%)

Res

erve

s/Sh

ort-T

erm

Deb

t (%

)

0

5

10

15

20

25

30

35

40

45

50

1Q01

3Q01

1Q02

3Q02

1Q03

3Q03

1Q04

3Q04

1Q05

3Q05

1Q06

4Q06

-10

40

90

140

190

240


BRL/USD Rate & Risk Spread

Exchange Rate (LHS)

Embi+ Brazil (RHS)

R$/

US$

Bas

is P

oint

s

1.82.02.22.42.62.83.03.23.43.63.8

Jan03

May03

Sep03

Jan04

May04

Sep04

Jan05

Jun05

Oct05

Feb06

Jun06

Oct06

Mar07

0

200

400

600

800

1000

1200

1400


D. Reducing Fiscal Vulnerabilities


Public Sector: Primary Surplus%

of G

DP

4.3

3.2

0

1

2

3

4

5

1999 2000 2001 2002 2003 2004 2005 2006


Public Debt: Stock

Selic Fixed Rate Inflation-Linked FX Others

% o

f GD

P

49.7%

-10

0

10

20

30

40

50

60

Jan03

Jul03

Jan04

Jul04

Jan05

Jul05

Jan06

Jul06

Jan07


Public Debt: Composition

Share of FX-Linked Domestic Debt Share of Fixed Rate Domestic Debt

%

34.5

-1.1-226

101418222630343842

Jan02

Jan03

Jan04

Jan05

Jan06

Jan07

0

5

10

15

20

25

30

35

40

Jan02

Jan03

Jan04

Jan05

Jan06

Jan07


Public Debt: Impact of a 1% DevaluationB

asis

Poi

nts

-5.0-5

0

5

10

15

20

25

30

Jan00

Jan01

Jan02

Jan03

Jan04

Jan05

Jan06

Jan07


Public Debt: Expected Trend

Market Consensus March 2007(annual data)

42.0

61.7%

4Q 0650.0%

38

43

48

53

58

63

1Q02

3Q02

1Q03

3Q03

1Q04

3Q04

1Q05

3Q05

1Q06

4Q06

2007 2009 2011

1Q02 through 4Q06 (quarterly data)

% o

f GD

P


Thank you!

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