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Inflation Targeting: Brazil’s Experience Seminar on Inflation Targeting Bank Al Maghrib

Inflation Targeting: Brazil’s Experience Seminar on Inflation Targeting Bank Al Maghrib Rabat, Morocco  April 4, 2007 Paulo Vieira da Cunha Deputy Governor. Overview Institutional Structure Issues Shocks & Expectations Increasing Predictability Reducing External Vulnerability

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Inflation Targeting: Brazil’s Experience Seminar on Inflation Targeting Bank Al Maghrib

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  1. Inflation Targeting:Brazil’s Experience Seminar on Inflation Targeting Bank Al Maghrib Rabat, Morocco  April 4, 2007 Paulo Vieira da Cunha Deputy Governor BAM/IMF April, 2007

  2. Overview Institutional Structure Issues Shocks & Expectations Increasing Predictability Reducing External Vulnerability Reducing Fiscal Vulnerability Outline BAM/IMF April, 2007

  3. I. Overview: Inflation Targeting Has Worked BAM/IMF April, 2007

  4. INFLATION TARGETING was introduced in June 1999 at a time of great macroeconomic uncertainty — but of low inflation It followed critical economic reforms Fiscal Responsibility Law Social Security Reform (partial) Privatization of SOE’s Trade and Capital Account Liberalization Restructuring and Recapitalization of Private Banks (PROER) Closure and/or Divestiture of Public Banks (PROES) History BAM/IMF April, 2007

  5. 1999: The New Macroeconomic Regime Floating Exchange Rate Inflation Targeting Solid Fiscal Anchor BAM/IMF April, 2007

  6. Targets vs. Consumer Inflation 18 15 Market Expectation 12 Feb 07 3.02 9 % p.a. 6 3 0 Jan Mar 99 00 01 02 03 04 05 06 07 08 BAM/IMF April, 2007

  7. Volatility of Inflation, GDP & Policy Rate GDP Selic (Policy) Rate Inflation Period Mean S.D. C.V. Mean S.D. C.V. Mean S.D. C.V. Prior to IT 4T94 – 2T99 10,4 9,9 95% 2,0 6,3 311% 35,4 14,1 40% IT 3T99 – 4T06 7,5 5,6 74% 2,5 3,5 139% 18,4 2,9 16% IT (excluding external shocks: 3T01 a 2T03) 3T99 – 4T06 6,0 3,3 55% 3,2 3,1 96% 17,5 2,2 12% IT (post external shocks) 3T03 – 4T06 5,4 2,3 42% 3,3 3,0 90% 17,4 2,5 14% BAM/IMF April, 2007

  8. Predictability of Monetary Policy 8 7 decision – expectation (t-3) 6 5 4 3 decision – expectation (t-1) 2 1 0 -1 -2 -3 Dec 01 Apr 02 Aug 02 Dec 02 Apr 03 Aug 03 Dec 03 Apr 04 Aug 04 Dec 04 Apr 05 Aug 05 Dec 05 Apr 06 Aug 06 Mar 07 Shaded areas: cycles of rate hikes BAM/IMF April, 2007

  9. SELIC (Policy) Rate Average value prior to IT regime 40 Average value during IT regime 30 % 20 10 96 97 98 99 00 01 02 03 04 05 06 07 BAM/IMF April, 2007

  10. Real Income & Inflation “Surprises” 1170 13 1149 11 IPCA (–) 12mo forward IPCAexp 1128 9 1107 IPCA > expectations 7 1086 Real income (IPCA deflator) 5 3 momovavg R$ 1065 3 1044 1 1023 -1 1002 -3 981 IPCA < expectations 960 -5 May 02 Dec 02 Jul 03 Feb 04 Sep 04 Apr 05 Nov 05 Jun 06 Jan 07 BAM/IMF April, 2007

  11. Credit to the Private Sector vs. Inflation Credit Average Tenure Total Credit/GDP 13 300 13 34 12 12 285 11 11 Market Expectations for Inflation 12 Months Ahead Market Expectations for Inflation 12 Months Ahead 10 270 10 30 9 9 Days 255 % p.a. % p.a. % of GDP 8 8 7 240 7 26 6 6 225 5 5 4 210 4 22 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan 02 02 03 03 04 04 05 05 06 06 07 02 02 03 03 04 04 05 05 06 06 07 BAM/IMF April, 2007

  12. Risk and Investment 143 2000 4Q06 Investment (LHS) 138 1700 133 1400 128 1100 1990=100 Basis points 123 EMBI+ Br (Q-2) (RHS) 800 118 500 113 108 200 1Q 00 1Q 01 1Q 02 1Q 03 1Q 04 1Q 05 1Q 06 2Q 07 BAM/IMF April, 2007

  13. 800 80% 700 70% 600 60% 500 50% US$ billion % of GDP 400 40% 300 30% 200 20% 100 10% 0 0% Jan/2001 Jan/2002 Jan/2003 Jan/2004 Jan/2007 Jan/2006 Jan/1997 Jan/1998 Jan/1999 Jan/2000 Jan/2005 Market capitalization - US$ billions Markets capitalization (% of GDP) Stock Market (Bovespa) Capitalization BAM/IMF April, 2007

  14. GDP Growth 2007 Projection: 4.1% 160 156 Average Growth 2004-2007: 3.7% 152 148 144 140 s. a., 1990 = 100 136 132 128 Average Growth 1999-2003: 1.8% 124 120 1Q 99 1Q 00 1Q 01 1Q 02 1T 02 1Q 04 1Q 05 1Q 06 1Q 07 4Q 07 BAM/IMF April, 2007

  15. Target & Model-Generated Forecasts IPCA Inflation: 12mo forward 9 Target 8 “Market” Scenario 1 7 “Reference” Scenario 1 6 1 % Forecasts 5 1 4 3 2 Jan Jun Nov Apr Sep Feb Jul Dec 06 06 07 08 08 06 07 08 BAM/IMF April, 2007

  16. Policy Rate: Expectations 6-mo Forward 15.2 14.6 14.0 % p.a. 13.4 12.8 12.2 11.6 Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar 06 06 06 06 06 06 06 06 06 06 07 07 07 BAM/IMF April, 2007

  17. II. Institutional Structure BAM/IMF April, 2007

  18. Key Parameters National Monetary Council sets the Inflation Target (Headline CPI-IPCA) June of each year for 2 years ahead Central Bank is charged with its attainment Band of ± 2% w/o escape clause The Monetary Policy Committee (COPOM) sets the policy interest rate (SELIC) The policy rate affects inflation expectations and actual inflation, with a lag BAM/IMF April, 2007

  19. Institutional Structure of IT President of the Republic • President Appoints Members of Monetary Council National Monetary Council • Policy Targets Agreement • 2 yr Rolling Forward Targets • President Nominates Governor and Board of Directors Governor Senate Public Markets Board of Directors Also sit as members of Monetary Policy Committee COPOM • Confirms Presidential Appointments • Committee hearings BAM/IMF April, 2007

  20. Inflation Targets & Bands: 2006 BAM/IMF April, 2007

  21. III. Issues BAM/IMF April, 2007

  22. A. Shocks & Expectations BAM/IMF April, 2007

  23. Price, Supply & Political Shocks: 2001-02 • Domestic & external shocks: • Energy Crisis • Argentina-I • Argentina-II • Brazil’s “fear of the left” political & risk aversion crisis • Sudden stop in external capital flows and aversion to claims denominated in local currency • Increase in country risk • Exchange rate depreciation • Pass-through to inflation (aggravated by backward-looking price setting rules for administered & regulated prices) • Inflation at 7.7% in 2001 and 12.5% in 2002, missing the target ranges (4% + 2% in 2001 and 3.5% + 2% in 2002). BAM/IMF April, 2007

  24. Political Shock: 2002 Devaluation of 131% BAM/IMF April, 2007

  25. Expectations Deficit: 2002 Difference between measured expectations and the mid-point of the Inflation Target for the year Based on the median of the sample of market expectations for year-end IPCA inflation Target: 3.50% E (X): 12.52% Actual:12.53% 2002 2003 2004 BAM/IMF April, 2007

  26. 2002: Inflation exceeded the target by a large margin The disinflation trajectory lost credibility Sharp increase in inflation expectations - medium term 2003: Central Bank announced an adjusted target trajectory The objective was to regain the lead over expectations, smoothing the cost of disinflation: Adjusted targets trajectory proposed in 2003: 2003  8.5% ± 2.5% 2004  5.5% ± 2.5% Rebuilding Confidence: 2003-2004 BAM/IMF April, 2007

  27. IPCA Inflation: 2002- 2004 YoY % change based on the 12momovavg BAM/IMF April, 2007

  28. In Feb/2003 the COPOM increased the policy rate to 26.50% and kept it at that level until May/2003 Reaffirmed commitment to fiscal responsibility Increase in the consolidated primary surplus: 4.25% of GDP in 2003 4.50% of GDP in 2004 Sharp FX depreciation from 1999 to 2002 produced a major external adjustment, with a significant increase in exports Benign external scenario contributed to exports surge and exchange rate appreciation Rebuilding Confidence: 2003-2004 BAM/IMF April, 2007

  29. Policy Rate: 2002- 2004 BAM/IMF April, 2007

  30. Inflation fell to 9.3% in 2003, from 12.5% in 2002 It fell to 7.6% in 2004 Successful disinflation allowed a return to the original targets set for 2005-2007: Target set in 2003: 2005 4.5% ± 2.5% Target set in 2004: 2006 4.5% ± 2.0% Target set in 2005: 2007 4.5% ± 2.0% Rebuilding Confidence: 2003-2004 BAM/IMF April, 2007

  31. Expectations Deficit: 2003 Difference between measured expectations and the mid-point of the Inflation Target for the year Based on the median of the sample of market expectations for year-end IPCA inflation Target: 8.50% E (X): 9.22% Actual: 9.30% BAM/IMF April, 2007

  32. B. Increasing predictability BAM/IMF April, 2007

  33. Rapid pace of economic recovery post-2003, led by a large surge in exports, fueled domestic demand and together the growth in external and domestic demand threatened the inflation target in 2005 — especially after a sudden expansion in fiscal outlays in Q4/2004 Consequently, starting in Sep-2004 the COPOM started on a tightening cycle that was to last one full year to Sep-2005, with an accumulated increase in the policy rate of 375bp Expectations and eventually inflation adjusted to retake the path of the inflation target Inflation expectations for 2006 were contained and approached the target. At end 2005 expectations for the next two years were in line with the target Consolidating the Regime: 2005-2006 BAM/IMF April, 2007

  34. Inflation Expectations vs. Targets Expectation t+1 Target t+1 Expectation t+2 Target t+2 1999 7,0 6,0 4,0 4,0 2000 4,3 4,0 3,8 3,5 2001 4,8 3,5 4,0 3,25* 2002 11,0 4,0** 8,0 3,75** 2003 6,0 5,5 5,0 4,5 2004 5,7 4,5 5,0 4,5 2005 4,5 4,5 4,5 4,5 2006 4,0 4,5 4,1 4,5 *CMN target: Jun/2001 (Resolução nº 2,842) ** CMN target: Jun/2002 (Resolução n° 2,972) BAM/IMF April, 2007

  35. Expectations Deficit: 2005 Difference between measured expectations and the mid-point of the Inflation Target for the year Based on the median of the sample of market expectations for year-end IPCA inflation Target: 4.50% E (X): 5.68% Actual: 5.69% BAM/IMF April, 2007

  36. Policy Rate: 2005 - 2007 BAM/IMF April, 2007

  37. Expectations Surplus: 2006 Difference between measured expectations and the mid-point of the Inflation Target for the year Based on the median of the sample of market expectations for year-end IPCA inflation Target: 4.50% E (X): 3.11% Actual: 3.14% BAM/IMF April, 2007

  38. Predictability of Monetary Policy Average Deviation: Actual vs. Expected Policy Rate Changes Lag: 1 month Lag: 3 months 1,2 4,0 3,59 1,06 3,5 1,0 3,0 0,8 2,5 p. p. 2,0 0,6 1,5 0,4 1,05 Mean: 1,00 1,0 Mean: 0,26 0,23 0,69 0,2 0,13 0,5 0,10 0,25 0,06 0,20 0,0 0,0 Dec 01 Sep 02 Oct 02 May 03 Jun 03 Aug 04 Sep 04 Aug 05 Sep 05 Jan 07 Dec 01 Sep 02 Oct 02 May 03 Jun 03 Aug 04 Sep 04 Aug 05 Sep 05 Jan 07 BAM/IMF April, 2007

  39. Real Interest Rates Rates for the 360d Fixed-to-Float Swap – BM&F 35 30 Avg 00/03: 15,0% 25 Avg 06/07: 9,3% Avg 96/99: 18,5% 20 Avg 04/05: 11,5% 15 10 7,9 5 Feb* 96 97 98 99 00 01 02 03 04 05 06 07 BAM/IMF April, 2007

  40. C. Reducing External Vulnerabilities BAM/IMF April, 2007

  41. Trade Surplus BAM/IMF April, 2007

  42. Trade Balance vs. Exchange Rate 12mo forward expectations 45 3,8 3,6 40 Trade Balance 3,4 35 3,2 30 3,0 BRL$/US$ 2,8 US$ bn 25 2,6 20 2,4 15 2,2 BRL/USD Rate 10 2,0 Jan Jul Jan Jul Jan Jul Jan Jul Mar 03 03 04 04 05 05 06 06 07 BAM/IMF April, 2007

  43. Expectations: Trade & Current Account Trade Balance Current Account 16 50 2005 2006 46 12 2005 2006 42 8 2007 38 2007 US$ billion 34 4 30 0 26 22 -4 18 -8 Apr Aug Dec Apr Aug Dec Apr Oct Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Dec 04 04 04 05 05 05 05 06 06 06 06 04 04 04 05 05 05 06 06 BAM/IMF April, 2007

  44. Expectations: BRL/USD Rate 3,2 Jun 04 3,0 Dec 04 2,8 Jun 05 R$/US$ 2,6 2,4 Dec 05 Jun 06 Dec 06 2,2 2,0 Dec Jun Dec Jun Dec Jun Dec 04 05 05 06 06 07 07 BAM/IMF April, 2007

  45. REER & Commodity Prices 153 165 Non-oil Commodity Price Index 155 138 145 Jun-1994 = 100 123 135 1995 = 100 125 108 Real Effective Exchange Rate 115 93 105 78 95 Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Feb 07 BAM/IMF April, 2007

  46. Buildup in Reserves Mar 07* 110 US$ 104.8 bi 99 Jan 05 88 US$ 54.0 bi Jan 06 77 US$ 56.9 bi 66 55 US$ billion 44 33 22 11 0 Jan Jun Nov Apr Sep Feb Jul Dec May Oct Mar 03 03 03 04 04 05 05 05 06 06 07 BAM/IMF April, 2007 *Mar 9

  47. Reduced External Liabilities Cumulative Reduction in FX-Linked Debt and BCB’s Accumulated Acquisitions in the FX Market since 1Q05 210 FX Market Total = $192.3bn 180 FX-Linked Domestic Debt 100.7 Swap 150 External Debt (Treasury + BCB) 120 US$ billion 90 26.7 60 9.1 30 55.8 0 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 BAM/IMF April, 2007

  48. Declining External Debt 50 240 45 40 190 35 30 140 Reserves/Short-Term Debt (%) Total External Debt/ GDP (%) 25 20 90 15 10 40 5 0 -10 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 4Q 01 01 02 02 03 03 04 04 05 05 06 06 Total External Debt/GDP Reserves/Short-Term External Debt by Residual Maturity BAM/IMF April, 2007

  49. BRL/USD Rate & Risk Spread 3.8 1400 3.6 1200 3.4 1000 Exchange Rate (LHS) 3.2 3.0 800 R$/US$ Basis Points 2.8 600 2.6 2.4 400 Embi+ Brazil (RHS) 2.2 200 2.0 1.8 0 Jan May Sep Jan May Sep Jan Jun Oct Feb Jun Oct Mar 03 03 03 04 04 04 05 05 05 06 06 06 07 BAM/IMF April, 2007

  50. D. Reducing Fiscal Vulnerabilities BAM/IMF April, 2007

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