Monetary Policy with a Volatile Exchange Rate: The Case of Brazil since 1999

INTRODUCTION

Brazil adopted inflation targeting and a floating exchange rate in 1999. This regime followed a brief period of fixed exchange rates, in 1994-98, when the Brazilian government used a currency peg to reduce and stabilize inflation. The so-called 'Real Plan' was successful in controlling inflation, but it also increased the financial fragility of the economy through high domestic real interest rates, a rising ratio of public debt to GDP and large current account deficits. When the global situation changed, in the wake of the East Asian and Russian crises of 1997-98, the Brazilian government abandoned the currency peg and moved to another macroeconomic policy regime, which persists to date.

The endurance of the current macroeconomic framework does not mean that the Brazilian economy has experienced smooth sailing since 1999. Quite to the contrary, a series of exogenous shocks have hit the economy in the past 15 years, coming from the world economy and the climate, which had a substantial impact on Brazil's exchange rate and power prices, respectively.¹ Moreover, Brazil also experienced significant domestic and government-induced structural changes, especially the expansion of the government's social safety net, which resulted in lower poverty, lower income inequality, credit expansion and financial deepening.

Brazilian monetary policy managed to keep inflation under control and maintain financial stability even in the face of the exogenous shocks and structural changes mentioned above. More specifically, in 9 of the 15 years since the adoption of inflation targeting, the Brazilian Central Bank (BCB) has managed to keep inflation within the bounds defined by the government. Even though inflation stayed above the government's central target during most of this period, it did not get out of control either. The average annual rate of consumer inflation was 7.1% in 1999-13, with a maximum of 12.5% in 2002 and a minimum of 3.1% in 2006.² The current central target is 4.5%, with an interval of tolerance of plus or minus 2 percentage points, but the BCB has been having difficulty meeting the target.³

The recent difficulty in controlling inflation comes mostly from the depreciation of the Brazilian real (BRL). In fact, the Brazilian average real exchange rate rose 20% in 2012-13, which in turn created a temporary inflationary and recessive shock.⁴