Brazil: Dangers of the ‘Good’ Inflation

In its next meeting, the CMN (National Monetary Council) should reduce the inflation target from 4.5% to 4%.

That Brazil has a long history of tolerating inflation is a notorious fact. In the early sixties, the annual inflation, which could come near to 20%, was seen as a fundamental revenue generating element (seigniorage) for the public sector to finance development. The inflation ended up coming close to three digits. During the military dictatorship (1964-1985), initially, inflation fell, but indexation, which was, then, highly regarded among the economists, was introduced. In the second half of the sixties, Milton Friedman would praise indexation as the second best to price stability. Later, with the rise of oil prices and large currency devaluations, not duly counteracted by monetary and fiscal policy, indexation led to hyperinflation, which would only come to an end more than a decade later, with the Real Plan.

Germans, who lived their hyperinflation nine decades ago, are still highly averse to inflation, presumably due to the far-off episode. In Brazil, however, such aversion to inflation does not seem to take place, despite the proximity to our hyperinflationary experience. And such fact becomes even more concerning when justifications of accepting “just a bit more of inflation” start taking place among the government.

The justification begins by splitting the inflation index into service inflation and other items. As the chart shows, service inflation has been systematically higher than total inflation, since the exchange rate went back to appreciating, after the great international crisis in the end of 2008, which brought the dollar all the way up to R$2.50.

The justification carries on, being said that greater inflation in services would be due to wage rises to the poor layers of society, which work mainly in the service sector. Hence, greater inflation in services would be a collateral effect necessary to the promotion of social integration.

Finally, the justification wraps up affirming that when bigger income equality is reached, service inflation will tend to fall, no longer being a problem.

This is a concerning narrative, for various reasons. Even if it is true that there is some association between the improvement in income distribution and service inflation, something yet to be proven, there needs to be some confrontation between this potential benefit with the risks of higher inflation in the long run, which are very concrete.

As shown in the chart, Brazilian inflation shows some signs of “schizophrenia”: the high service inflation has been partially offset by durable goods deflation. The price of durable goods has fallen because the low level of global activity has held in check the prices of tradable items, and the BRL was appreciating until last January. Services, on the other hand, have been able to raise its prices in response to the continuing demand expansion, through private and public consumption, since they cannot be imported.

The maintenance of the current status quo is not to be taken for granted. The recent depreciation of the BRL is one of the threats. Even with lower international prices, tradable itens will have their prices raised in BRLs, should the exchange rate persist at current levels, or depreciate even further. The recovery of global economy, even though unlikely in the short run, when it happens, will mean higher tradables prices. With service inflation near 8%, it will be difficult to keep fullfilling the inflation target, under heated domestic demand.

Such threats are not immediate. However, that is the very reason why it would be convenient to address them now. The time to fix a roof is when it is not raining. Narratives that justify tolerance with inflation, no matter how well-intended, should be dismissed in order to avoid the risk of repeating past and costly mistakes.

Also, to reassure the commitment with the inflation targeting system, it would be advisable for the CMN (National Monetary Council), in its next meeting, to reduce the inflation target for 2014, from the current 4.5% to 4%, a figure closer to inflation targets practiced worldwide.