1 April 2001 Banco Central do Brasil The Case of Brazil The Case of Brazil The Managed Floaters: Float or Sink? Float! Float! Ilan Goldfajn

2 How the Inflation Targeting Regime has Operated in the Last Two Years.How the Inflation Targeting Regime has Operated in the Last Two Years. The Effect of the External Shock in 2001 and Pass-throughThe Effect of the External Shock in 2001 and Pass-through Sensitivity to Interest Rates and the Effect of DepreciationSensitivity to Interest Rates and the Effect of Depreciation

3 Inflation Rate - IPCA (% over year ago) Dotted lines represent the inflation targets for 1999, 2000 and 2001 Inflation Targeting 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% JanAprJulOctJanAprJulOctJanAprJulOctJanAprJulOctJan Mar

4 Market Inflation Expectations median of IPCA for 1999, 2000, 2001 and 2002 (daily figures: June 24, 1999 to April 20, 2001) Source: Investor Relations Group / Banco Central Inflation Expectations Jul 24 Jul 29 Sep 02 Oct 08 Nov 17 Dec 22 Jan 28 Mar 03 Apr 11 May 18 Jun 23 Jul 28 Sep 01 Oct 09 Nov 16 Dec 21 Jan 29 Mar 07 Apr 11 (%)

5 IPCA variation rate (%) Used Sample Projection Period Occurred Inflation Structural Model Market Projections Near VAR Model 1994:3 a 1999:2 1999: :3 a 1999:3 2000: :3 a 1999:4 2000: :3 a 2000:1 2000: :3 a 2000:2 2000: AVERAGE ERROR AVERAGE ABSOLUTE ERROR AVERAGE QUADRATIC ERROR Evaluation of Inflation Forecasts Inflation Targeting

6 /* 2001 estimates * GDP (% real variation) Economic Activity

7 Interest Rate 44.99% Over-Selic Rate % p.y % (daily figures: January 4, 1999 to April 20, 2001) JanAprJulOctJanAprJulOctJanApr

8 Year cumulative data Target Occurred Fiscal Targets - Primary Surplus R$ billion MarJunSepDecMarJunSepDecMar

9 Net Public Sector Debt Average Maturity * - Public Debt JanMarMayJulSepNovJanMar 0001 In months

10 External Shock and the Reaction Important External Shocks: U.S. Slowdown (recession?) and ContagionImportant External Shocks: U.S. Slowdown (recession?) and Contagion There is no fear of floatingThere is no fear of floating In principle exchange rate is the only buffer. However, there is a pass-through from depreciation to inflation. Fear of Inflation.In principle exchange rate is the only buffer. However, there is a pass-through from depreciation to inflation. Fear of Inflation. Pass-through is endogenous depends on output, RER, credibility, policies and etc.Pass-through is endogenous depends on output, RER, credibility, policies and etc.

11 Net Foreign Direct Investment - Equity Capital Accumulated in the year Source: Central Bank of Brazil FDI: U.S. Slowdown. Size of Decline? * 2001 year projections FDI excluding Privatizations FDI in Privatizations Source: Central Bank of Brazil US$ billion *

12 US int. rate BP US int. rate x InflationR-squared Number of BPdifferentialcountriesobservations Whole sample 0,450,00-0,011,070, (0.13)**(0.00)(0.01)(0.20)** Intermediate regimes 0,050,00-0,051,170, (0.19)(0.00)**(0.02)**(0.38)** Free-floating regimes 0, ,000,590, (0.18)**(0.00)(0.01)(0.30)** Notes: 1. All the regressions contain country fixed effects which are not reported to save space. 2. White heteroskedasticity-consistent stardard errors are in parenthesis. 3. ** and * mean that the estimate is statistically different from 0 at the 5% and 10% significant level respectively. respectively. Domestic Interest Rate Responsiveness to US Interest Rate in Countries without Capital Controls Econometric Exercise

13 No Fear of Floating. Contagion? Dollar/Euro e Real/Dollar Behavior Average Rate % Deviation Jan/ Feb 8 Mar/ Apr 12 May 2 Jun/ Jul 7 Aug/ Sep 10 Oct 1 Nov/ Dec/00 9 Jan/ Feb 15 Mar 5 Apr/01 Dollar/EuroReal/Dollar (Observed average Jan/00 to Apr/01 = Real/Dollar 1,88 and Dollar/Euro 0,92)

14 Pass-Through Comparison Months Short Sample Long Sample Paper G&W RegressionregressionAmerica 3 months months after 1 year months Fear of Inflation and Pass-through

15 Passthrough Coefficient Evolution of the Passthrough Coefficient :11997:21997:31997:41998:11998:21998:31998:41999:11999:21999:31999:42000:12000:22000:32000:4

16 The Policy Reaction and the Effect Economy was growing fast. Good timing for the required fiscal and monetary tightening.Economy was growing fast. Good timing for the required fiscal and monetary tightening. Monetary policy may be more effective than in previous regime. Signs on term structure and credit growth are encouraging. Signs of sales slowdown.Monetary policy may be more effective than in previous regime. Signs on term structure and credit growth are encouraging. Signs of sales slowdown. There is sensitivity to the exchange rate. Is the elasticity large enough? Would depreciation be contractionary this time?There is sensitivity to the exchange rate. Is the elasticity large enough? Would depreciation be contractionary this time?

17 GDP Growth: No pro-cyclical policy GDP and Industrial Production Real variation cumulative in 12 months I III1997 I III1998 I III1999 I III2000 I III GDP at market prices Industrial production

18 Economic Activity Month Percentage variation Perspective Month 1/ Year12-month 1. Commerce - Billing (São Paulo) - Billing (São Paulo) March Slowdown - SPC and Telecheque - SPC and Telecheque March Slowdown - SPC - SPC March Slowdown - Consumer confidence index - Consumer confidence index March Down 2. Industry - Production - Production February Sales - Sales February Employment - Employment February Installed capacity utilization (CNI) - Installed capacity utilization (CNI) February Labor market - Unemployment rate - Unemployment rate February Real income - Real income January Source: Fcesp, ACSP, IBGE and CNI 1/ Seasonally adjusted series.

19 Trade Balance Trade Balance - monthly and cumulative in 12 months (US$ billion) Monthly - left scale Cumulative in 12 months - right scale JanMaySepJanMaySepJanMaySep Mar

20 Fiscal Results Sensibility analysis % of GDP Itemization Basic scenario Exchange rate (1 pp aa) Selic (1 pp aa) GDP (1 pp aa) Net Debt Nominal - 12-month % of GDP Itemization Exchange rate (1 pp aa) Selic (1 pp aa) GDP (1 pp aa) Net Debt - 12-month variation Nominal - 12-month variation

% 3.00% The Fiscal Adjustment Program Fiscal Targets for PRIMARY SURPLUS % of GDP % 3.10% % % 3.25% 2002 * /* Preliminary

22 –No Fear of Floating but Fear of Inflation. Pass- through from exchange rate has been moderate. Future? –Contractionary Monetary and Fiscal Policy are being implemented in a booming economy. –Instruments seem to be operating. Exchange rate buffers most of the shock but interest rate increase should guarantee inflation on target. Fiscal policy must maintain debt stability. –“Sudden stop” is very tough for any regime. Conclusions