The Low Inflation target benefits the Worker not the Opposite
In a recent interview, President Lula castigated the current inflation target, sticking to his new habit of throwing banana peels in the street, then crossing them and slipping on them. In his words: Why is the [central] bank independent, and are inflation and interest rates so? You set an inflation target of 3.7%, and when you do that, you’re forced to “tighten” the economy further to 3.7% [the target in 2022 was, in fact, 3. 5%].
Why do I have to earn 3.7%? Why not do 4.5% like we did? The idea that seems to guide the president’s proposal is not difficult to understand: it is a question of raising the inflation target so that the central bank can, in appearance, lower the base interest rate, allowing faster economic growth. criterion of truth (otherwise one would believe that the moon is really made of cheese.)
In this case, it is a false proposition, and its ultimate effect will be the opposite of the desired proposition, i.e. rates higher real interest rates and lower growth There is a crucial tacit assumption in the presidential proposal, which is that – even in the face of public pronouncements about a target for higher inflation – people will not change their behaviour, in particular with regard to the fixing of prices and wages.
Hard to believe in such things. There are prices in the economy that remain constant over certain periods. The best example, but not the only one, is the salary, which, once agreed, usually does not change for a year. Thus, when negotiating it, workers must take into account not only inflation since the last adjustment and objective labor market conditions (whether there is a shortage or an excess of vacancies, for example), but also, And most importantly, that is, inflation during the period Salary will remain unchanged.
If expected inflation is low, the provision against inflationary erosion included in the salary will also be low; If high, the adjustment will be larger today to offset expected losses over the next 12 months. In other words, expectations about the future behavior of inflation affect wages today. In the same way, expected inflation – today – affects all prices in the economy: the higher it is, the greater the current price increase. (This contribution to macroeconomic theory and practice helped Milton Friedman, Edmund Phelps and Robert Lucas win the Nobel Prize in economics.)
British Columbia estimates that a one percentage point increase in expected inflation leads to an increase of about half a percentage point in current inflation, an effect that is far from modest. Of course, inflation expectations can be good or bad. However, when it is the government itself, by decision of the National Monetary Council (body composed of the Minister of Finance, the Minister of Planning and Budget, as well as the President of the Central Bank) which indicates that the central bank should aiming for its highest levels, it is reasonable to conclude that expectations Inflation must rise.
This could in fact become more complicated if BC enjoyed significant reliability, measured, for example, by the proximity between inflation expectations and the inflation target. However, this is not what we notice. According to the latest Fox survey, projected inflation rates for 2023, 2024 and 2025 are 5.5%, 3.9% and 3.6% respectively against targets of 3.25%, 3.0% and 3 .0% in the same years.
Other measures of expected inflation are also showing above-target values, indicating that even with plenty of time to implement monetary policy, the public lacks confidence in the central bank’s ability to provide inflation around the targets set by the CMN. In other words, expected inflation must be higher than the new inflation targets.
This should lead, as we have said, to an acceleration of inflation, and therefore to the need for a reaction from the Central Bank, in accordance with the rules of its monetary policy. Regardless of the exact form of the rule, all central banks that have historically been able to keep inflation around target have adopted the same principle: if inflation rises (or falls) by one percentage point , the interest rate must rise (or fall) by more than one percentage point. The intuition of such a principle is less complex than it seems.
By raising the base rate more than inflation, the central bank ensures that the real interest rate rises when inflation is highest, slowing the economy and therefore inflation. Similarly, when inflation falls, the central bank lowers the real interest rate and leads to stronger growth in activity and prices. If this principle is not respected, any central bank will lose its ability to stabilize inflation.
Thus, in the scenario of acceleration of inflation motivated by the raising of the target, the Copom will have to raise the real rate of the euro, otherwise it will lose control, with a negative impact on growth and employment. As we warned, this is the opposite of what is believed to be the result of the objective increase. Banana peeling is a high risk sport. Alexander Schwarzman was Director of International Affairs at the Central Bank and Chief Economist at ABN Amro and Santander. He is a founding partner of Schwartsman & Associados.