Catch 22 Situation

It was indeed a Catch-22 situation facing Tombini in July 2015: raising interest rates could potentially contain Brazil’s above-
10% inflation but in the short run, push up the already-high unemployment rate. Loosening or inaction on monetary policy,
on the other hand, could risk a continued buildup of inflation expectation.

Limited Toolsets

Tools available at Tombini’s disposals were limited. In terms of monetary policy, he had limited room to raise interest rates
given Rouseff’s pressure to increase employment and stimulate economic growth. As a central banker, he also had no
purview over fiscal policy. Even if he had it, rooms for fiscal policy are constrained by rising public debt (from circa 63% of
GDP in 2014 to above 73% in 2015) and negative primary balance (close to -2% of GDP). The drop in Brazilian Real’s value
against its major trading partners also increased import costs and consumer prices – contributing to imported inflation.

To resolve Tombini’s dilemma, it helps first understand high-level economic structure of Brazil:

Understanding Brazil’s economic structure:

In the years preceding 2015, Brazil’s economy is highly open with trade (import + export) averaging 32% during 2010-2014
period. The import content consists primarily (70%) of factors of production: machinery (24%), chemical products (21%),
mineral products (including refined petroleum, 16%) and transportation (9%). Export content, on the other hand, tends to
be primary resources e.g. iron ore, crude petroleum, soybean and raw sugar. Heavily reliant on commodity export to China
(22%), Europe (20%) and the US (11%) which were all slowing down, Brazil is vulnerable to international tailwinds.

Inflation Stays High Despite High Interest Rates

Despite the conventional Economics 101 teaching that higher interest rate reduces inflation in the short run, in Brazil’s case,
this may not be true, in my view, for two possible reasons:

1. Inflation is driven by higher cost due to depreciation in Real, in turn caused by capital flights away from emerging
markets (like Brazil). Global investors’ perception of Brazil had deteriorated because of the sharp drop in crude
oil price, slowdown of China and corruption scandals surrounding Petrobras and Rouseff’s administration. This
caused a net capital outflow in Brazil and hence, depreciation of Real. The perceived risks far outweighed the higher
interest rates.
2. Despite rate hike, inflation remained sticky because the market expects the inflation to remain high. Tombini’s
perceived lack of independence and credibility and reluctance to stick to inflation target severely limited the
effectiveness of interest rate hike in containing inflation.
3. Economic recession has not translated into drop in price level because there is a dampening effect caused by
upward shifting of supply curve due to the higher cost of business.

Notice the number of times “perceived” and “perception” are used. Any further rate hikes would do little in overturning global
investors’ capital outflow and changing market’s expectation for high inflation. In fact, as shown in Exhibit 4, SELIC overnight
rates lag Consume Prices changes, showing that the central bank was reactionary towards upswings in consumer prices
and the move has not been effective. On the flip side, it further damps real GDP growth already weakened by commodity
slump. Therefore, I would argue for Tombini to pause/suspend further rate hikes.

Instead, there are other steps Tombini and his successors can take in the short term and long terms (if he holds on to the
helm, that is):

Short-term Measures: Guiding and Anchoring Perception, Reducing Cost of Business

 Emphasize the role of central bank and its independence from the executive branch
 Positive marketing and branding of fiscal responsibility by joint effort of central bank and Rouseff’s administration
o streamlining of public sector, downsizing bloated government
o embarking on 90-day program to reduce red tapes by focusing on low-hanging fruits
o re-evaluating public projects and re-prioritizing those with meaningful returns
 Reinstate global investors’ confidence of Brazilian economic future by
o signing more bilateral free trade agreements with non-traditional partners (e.g. Southeast Asia)
o simplifying tax, land, bankruptcy etc. rules and regulations

Long-term Measures: Real Reforms for Sustainable Economic Growth