Inflation, Interest Rates and The Exchange Rate in Brazil


The macroeconomic literature contains certain relationships and tautologies linking inflation, interest rates and the exchange rate which are very useful.

ByAntonio Carlos Lemgruber

For example, we have the well-known difference between nominal interest rates and real interest rates, although economists have different ways to establish this relationship: some look to the future (inflation expectations) and some look to the past (actual inflation in the period).

A similar situation occurs when we talk about interest rates and exchange rates. By definition, the forward exchange rate is different from the spot exchange rate by exactly the interest rate differential between two currencies. But this is entirely different when the market considers uncovered or unhedged interest rates, because in this case what matters is the actual exchange fluctuation in a certain period in comparison to the expectations of a certain market player. Naturally, he will only choose a currency with a high nominal rate if he “expects” that an eventual devaluation in the period will not destroy some big interest rate differential between two countries and currencies during a certain period of time.

However, we really want here to raise in this piece a third link: the one between inflation and exchange rate changes. In the Brazilian case, although many economists don’t like this specific measurement, I am quite comfortable with the concept of IGP or General Price Index, which is after all a weighted average of wholesale prices and consumer prices. Very well: in the last 12 months, inflation in Brazil measured by this IGP has been around 12/13%.

This is a big surprise to me (and a major preoccupation of course) because in the same period there was a major appreciation of the Brazilian currency. In other words, assuming that a measurement of inflation can be made by dividing goods and services in three categories: tradable goods, non-tradable goods and of course services, assuming that tradable goods represent a significant share of the index, and given the very strict monetary policy of the last few years, one should expect practically DEFLATION in Brazil between 2004 and 2007.

Something seems to be wrong. In the past few years, the currency appreciated against the dollar by more than 100%, while IGP kept accelerating. Even neglecting the concept of effective exchange rates (which considers other currencies beyond the dollar), it is easy to see that the so-called Real Exchange Rate with respect to the dollar (discounting inflation of the local currency) had a dramatic appreciation in Brazil.

I am highly confident that – comparing to 1994-1997 – we are back to a real exchange rate “worse” (from the point-of-view of external trade and economic growth) than the one-to-one parity of the Plano Real of 1994 (as a matter of fact, in 1995 the exchange rate went down to 0.8 – and I really fear that we might be there again, in real terms of course).

This is to me one of the major unsustainable problems of the Brazilian economy in 2008: the level of the real exchange rate. We are back to the lack of realism (or populism) of the late forties, the fifties and early sixties – which was repeated in the nineties. Inflation was accelerating severely in Brazil, but the exchange rate was kept fixed between 1947 and 1961 (and something similar happened after the Plano Real of 1994). Now, in the new century, the real is appreciating in the floating regime, due to the highly risky attitude taken by international investors (mainly hedge funds) who love high nominal interest rates, do not fear a major devaluation of the Brazilian currency, and mounted a speculative attack on the Brazilian currency (including W. Buffett, among others).

This is not realistic. And it seems that the Central Bank is willing to “help” and double the bet, by: raising interest rates even more, in order to try to keep inflation under control and naturally to provoke an additional appreciation of the real. Without any exaggeration, this is a suicidal policy: Brazil cannot afford a repetition of the fifties or the nineties – extending to 2008 – when the manufacturing sector was severely hurt by the overvalued exchange rates.

High commodity prices are keeping an “artificial” trade surplus, but the quantity or volume indexes for manufactured exports are frightening low – and the same is true for domestic production designed for import substitution. There is now an authentic boom of imports of all kinds.

Something must be done. President Lula perceived that low inflation is politically more important than high unemployment. After all, low inflation provides happiness to the whole population, while high unemployment (unfortunately, but being realistic) affects only the ones who are really unemployed and their families (for example, 100% of the population is glad with low inflation against “only” 10% unemployed and families).

However, we can perceive now pressures which are very similar to the early sixties and to 1999, as far as the exchange rate is concerned, in spite of the high level of international reserves. Just read the excellent articles of former Minister Delfim Netto in Valor Econômico (in Portuguese).

On the other hand, it is difficult to imagine that commodity prices in US$ will be maintained at the present high levels (soybean, corn, iron ore, oil, etc.). This might result in exactly the opposite effect of 2003-2008: a devaluation of the real in 2008-2009 might be somewhat compensated by a decline in US$ prices of tradable goods.

In our opinion, monetary policy is at a limit situation. The way to do something now is to do precisely the old textbook story, the right thing to do: expenditure-reducing and expenditure switching policies on a simultaneous basis. Cuts in Government spending and currency devaluation. Leave interest rates where they are. And do not raise taxes. And please replace inflation target models for exchange rate anchor models as soon as possible. Just like in 1999 and 2002, a once-and-for-all devaluation will not cause inflationary pressures if but only if fiscal policy is conservative. This is the key.

Is it possible to convince Lula to undertake such change in economic policy as former Minister Roberto Campos did in the early sixties (as a matter of fact, twice – under President Janio and under President Castelo Branco) and some of the new economic advisors of President Cardoso did in 1999? Yes, but this will probably require new names like Delfim Netto and Afonso Pastore as advisors, giving lectures to Minister Mantega, Central Bank President Meirelles and the Central Bank Directors. A very difficult proposition.

Let us wait and see. If policy is not changed, 2009 in Brazil could be a disaster for inflation as well as economic growth and the balance-of-payments. Just like 1974 was a disaster, after the Brazilian miracle of 1967-1973, due to the same impression or feeling that Brazil is (or was) an island of prosperity.


Latin America