This Selected Issues paper and Statistical Appendix on Brazil looks at price developments following the floating of the Real in mid-January 1999. The paper highlights that the experiences in East Asia—Indonesia, Korea, Malaysia, Philippines, and Thailand—all show that the pass-through from devaluation to inflation has been lower than expected, with the exception of Indonesia. The paper analyzes the competitiveness and export performance of Brazil. Effects of high interest rates and currency depreciation on Brazilian enterprises are also analyzed.


This Selected Issues paper and Statistical Appendix on Brazil looks at price developments following the floating of the Real in mid-January 1999. The paper highlights that the experiences in East Asia—Indonesia, Korea, Malaysia, Philippines, and Thailand—all show that the pass-through from devaluation to inflation has been lower than expected, with the exception of Indonesia. The paper analyzes the competitiveness and export performance of Brazil. Effects of high interest rates and currency depreciation on Brazilian enterprises are also analyzed.


1. With the adoption of a floating exchange rate regime early this year, the Brazilian authorities indicated their intention to put in place as rapidly as possible a formal inflation targeting framework. Though they moved quickly to put this framework into place, they followed a careful and well-organized plan to meet the particular institutional, economic, and financial market circumstances of Brazil. This included outreach consultations and discussions with central banks that have experience with this kind of framework, analytical and empirical work to ascertain key macroeconomic relations in the Brazilian economy, and several actions to ensure an institutional and operational framework suitable for an effective monetary policy under inflation targets. This section describes the preparatory steps taken by the Brazilian authorities in adopting an inflation targeting framework, as well as the recent actions to bring it into effect formally.

A. Outreach Consultations: Lessons from the International Experience

2. In their preparatory work for adopting an inflation targeting framework, the Brazilian authorities sought the benefit of an outreach consultative seminar that would permit open and wide discussions on experiences with this kind of framework. For these purposes, a Seminar on Inflation Targeting, jointly organized by the Central Bank of Brazil and the IMF’s Monetary and Exchange Affairs Department took place in Rio de Janeiro during May 3–5, 1999. The seminar aimed at reviewing the experience of a number of developed and emerging economies in implementing inflation targeting frameworks and providing an opportunity for Brazilian economists and policymakers to discuss their plans to implement a similar framework in Brazil. Experts from Australia, Canada, Chile, Israel, Mexico, New Zealand, Sweden, the United Kingdom, and the United States made presentations on their country experiences. Also, technical staff from the Central Bank of Brazil made a presentation on their preliminary work and plans for the adoption of an inflation targeting framework in Brazil. These presentations were subjected to review and comments by experts from the attending foreign central banks and from several Brazilian universities and institutions.

3. A wide consensus emerged from these discussions on the key aspects of a successful implementation of inflation targeting. Low and stable inflation was singled out as the primary long-run objective of monetary policy, and inflation targeting was regarded as an effective framework for guiding monetary policy. In particular, inflation targeting was seen as providing a nominal anchor both for monetary policy and inflation expectations, making this anchor identical to the long-run objective of monetary policy; providing more transparency and accountability to the design and implementation of monetary policy; facilitating its communication, understanding, and assessment; and providing effective policy guidance by focusing policymakers’ attention on the long-run consequences of short-term policy actions.

4. Inflation targeting was seen to dominate alternative nominal anchors, particularly monetary anchors because of the observed instability of money demand in most industrial and emerging economies, as well as because of the unstable relationship between money aggregates and inflation resulting from a number of factors, including domestic financial liberalization, capital account opening and growing international financial diversification, currency substitution, and technological innovation. Also, an inflation targeting regime was seen to be consistent only with reasonably flexible exchange rate regimes. In this context, the predominant view was that effective inflation targeting is inconsistent with the targeting of other nominal variables. If inflation is chosen as the nominal anchor, all other competing nominal anchors (such as monetary aggregates, the exchange rate, or wages) should preferably be eliminated or, at a minimum, be relegated to a subsidiary nonbinding status. In particular, exchange rate movements are important to the extent that they threaten the achievement of the inflation target.

5. Instrument independence and absence of fiscal dominance were singled out as key preconditions for a successful implementation of an inflation targeting framework. In particular, inflation targeting was seen to be inconsistent with weak fiscal policies, and with the monetary financing of nonfinancial public sector deficits, the financing of public or private financial sector deficits, and the accommodation of public-sector increases of tariffs, government services, and wages.

6. The key operational requirements for a monetary policy framework based on inflation targeting were identified. These include, an explicit quantitative target for future inflation, a framework for producing official inflation forecasts, a timely use of effective monetary policy instruments, the selection of a price index, the tolerance interval (range, ceiling, or point), the target horizon, the speed of convergence to the long-term desired levels (gradualism versus quick convergence), exemptions or escape clauses,2 and the transparency and accountability framework. It was particularly important that the central bank be able to make full use of its monetary policy instruments in a timely and forward-looking way whenever monetary policy action was called for. Taking into account the uncertain lags observed between policy actions and their intended macroeconomic effects and making an unconstrained use of an effective policy instrument, usually a short-term monetary policy or interbank interest rate, were seen as key requirements in this regard. The representatives of countries that have experience with inflation targeting noted the need to have several models in place (including, structural and vector autoregression models) and use them for consistency checking against each other. They also emphasized the need to rely on private sector forecasts and on inflation expectations derived from market-based financial instruments.

B. Technical Underpinnings: The Mechanism of Monetary Policy Transmission in Brazil

7. To guide the implementation of inflation targeting and against the background of the outreach consultations, the Research Department of the Central Bank of Brazil has developed some tools to help guide monetary policy decisions. These include some simple structural models of the transmission mechanism of monetary policy to prices, complemented with short-term inflation forecasting models, and surveys of market expectations of inflation, growth and other relevant economic variables.

8. A family of structural models was estimated aimed at identifying and simulating the mechanism of monetary policy transmission in Brazil, including the main channels of transmission as well as the lags involved. This family of models can be summarized by a simple structural model with the following basic equations: (i) an aggregate demand equation expressing the level of aggregate demand as a function of lagged aggregate demand, the real interest rate (ex-ante or ex-post), and the real exchange rate; (ii) a Phillips curve expressing the rate of inflation as a function of the lagged inflation rate, the output gap, and the nominal exchange rate (and imposing a condition of long-term neutrality of the output gap on inflation); (iii) an uncovered interest parity condition relating the differential between international and domestic interest rates with the expected rate of devaluation of the domestic currency (the Real), and the risk premium; and (iv) an interest rate rule, alternatively fixed rules on nominal or real interest rates, Taylor-type rules (with weights for contemporaneous deviations in inflation and output), or forward-looking rules (with weights for deviations of expected inflation from target inflation).

9. Several channels of transmission of monetary policy are recognized as relevant for the Brazilian economy. These include the interest rate (a policy instrument), the exchange rate, asset prices, expectations, credit or money aggregates, wages, and wealth. In the context of the simplified models estimated by the Central Bank of Brazil two main transmission channels were identified: (i) an indirect channel: by affecting the output gap, the interest rate affects the inflation rate with a minimum lag of two quarters; and (ii) a direct channel; changes in the nominal exchange rate affect the inflation rate contemporaneously.

10. The estimation of structural models was complemented by a set of short-term models aimed at ascertaining the mechanism of formation of inflation expectations. The development of reliable forecasts of inflation is a key element because the inflation targeting framework is necessarily forward-looking given the lagged effects of monetary policy. These complementary models include Vector Autoregressive (VAR) models and Autoregressive Moving Average (ARMA) time-series models and serve two main purposes:(i) providing an alternative short-term forecast for the inflation rate and, therefore, permitting a consistency check with the forecasts resulting from the structural models, and (ii) permitting the use of the inflation forecast resulting from these models for the purposes of estimating (with the structural model) the “ex-ante” interest rate (which is an explanatory variable in the aggregate demand equation in some of the estimated structural models) as well as in the forward-looking interest rate rule (which is one of the equations in the structural models).

11. Simulations of the models require definitions on: (i) the interest rate rule (a fixed nominal rate or a Taylor-type rule or a rule based on the deviations of expected inflation from target or a predetermined trajectory for nominal or real rates); (ii) the inflation target whenever the interest rate rule does not involve a fixed nominal rate; and (iii) a mechanism for the formation of inflation expectations. Once these definitions are provided the following results are obtained from the models: (i) inflation forecasts (central path and confidence intervals around the median) with definitions of a measure of dispersion (variance) and of risks (asymmetries); (ii) forecasts for output; (iii) the trajectory for interest rates (both, nominal and real) resulting from the various predetermined reaction functions; and (iv) dynamic simulations of exogenous shocks.3 Simulations permit the visualization of the mechanism of transmission of monetary policy implicit in these simplified models, with the interest rate affecting the nominal exchange rate contemporaneously and the output gap with a lag; the nominal exchange rate affecting the real exchange rate and the inflation rate contemporaneously; the real exchange rate affecting the output gap; and the output gap affecting the inflation rate with a lag. The simulation of the structural models is based on the selection of a core scenario which involves the most likely hypothesis and a set of alternative scenarios representing the perceived risks of departure from the basic hypothesis. A careful assessment of the various hypotheses is a necessary condition for balanced decisions on the instrument of monetary policy.

12. The output from these models is but one of several elements that are taken into account in making policy decisions. In particular, forecasts cannot be limited to those produced by models.4 Alternative sources such as the yield curve, and market surveys and forecasts need also be taken into account. In this regard, the Central Bank of Brazil conducts a Survey on Market Expectations and regularly publish the medians of several market forecasts on prices, GDP growth, trade and current account balances, and primary and nominal fiscal balances. The surveys include forecasts for the national consumer price index (IPCA)—which, as explained below has been chosen as the reference index for the inflation targeting—and other price indexes (IGP-DI, IGP-M, IPC-FIPE, and INPC); the median forecast for the GDP; and the expectations for the trade balance, the current account, and the fiscal primary and nominal balances.

13. Inflation targeting involves an explicit strategy for monetary policy consistent with the observed lags existing between adjustments in the monetary policy instruments and their effects on inflation and output The central bank is expected to act in a preemptive way to influence the future trajectory of the inflation rate in order to meet the preestablished targets. The question is to determine when pre-emptive policy action is necessary and how aggressive it should be. In deciding on these matters, the Central Bank of Brazil as well as other central banks face important risks. For instance, if the central bank waits until rising inflation becomes a public concern, then it could be too late because inflation will most likely became entrenched in people’s expectations and decisions. On the other hand, poorly timed policy tightening could have adverse effects on employment and output. Against this background, the Central Bank of Brazil plans to inform the public on the expected path of inflation envisaged by the Monetary Policy Committee. To reflect the uncertainty involved in the forecasts, it would be helpful that the information released to the public includes the expected central path as well as various intervals reflecting differing degrees of uncertainty around the central path.5

C. The Main Monetary Policy Instrument

14. In Brazil, the interest rate is the most important instrument of monetary policy available to the central bank. 6 Specifically, the central bank influences directly the interest rate in the interbank market (known as the primary rate or SELIC rate). It is through changes in this particular interest rate that the central bank affects indirectly other interest rates in the economy as well as the output gap and the inflation rate. In Brazil, the banks’ demand for reserves has two main components: the reserve requirements on deposits (particularly, on demand deposits) and the excess reserves that banks keep to satisfy their normal operations. In principle, open market and rediscount operations by the central bank are the main sources of funds in the market for banks’ reserves, even though the latter has not been used for several months now.

15. The control of liquidity through open market operations consists of the buying and selling of treasury bonds, either from the central bank’s portfolio or new issuance, or bonds issued by the central bank. In executing monetary policy, the central bank selling (purchasing) of bonds to the banking system leads to a reduction (increase) in the banks’ liquidity. There are two types of buying (selling) of bonds by the central bank: swaps and final operations. In the swaps, the central bank lends (borrows) funds for a specified term—frequently one day (overnight)—buying (selling) bonds under the commitment to resell (repurchase) them at a future date and at a predetermined price. In this type of operation (called informal auction or “go-around”), the central bank taps the market through selected dealers, periodically assigned by the central bank and selected among those more active in the financial system. In the final operations, the bond becomes part of the portfolio of the buyer. This final purchase (sale) by the central bank is done through formal and informal auctions, in which all financial institutions can participate.7 At present, the formal auctions of central bank bonds are held weekly, typically on the business day before Wednesday. The treasury bonds auctions are also held weekly, frequently on Thursdays. The central bank places in the formal auctions the newly issued bonds (primary market) as well as maturing bonds held in its portfolio. The central bank is withdrawing gradually from the primary market.

16. The central bank monitors the bank reserves market so as to adjust the liquidity in the banking system daily. The daily liquidity settlement is done through repeated go-arounds. Before the market opens, the central bank estimates if there is an excess/lack (the central bank is undersold/oversold) of reserves in the banking system. This estimate is based on operations that affect the banks’ reserves and obtained through consultations with various sources, among which are the dealers. Considering conditions in this market as well as other factors, such as interest rates in the forward market, the rate of inflation and its forecast and the current monetary policy, a desired interest rate is established, which is normally conveyed to the market through a “go-around “ In the execution of monetary policy, all the open market operations, backed by public bonds, are done through the Special System of Clearance and Custody (SELIC), a data processing system set up to register all transactions involving public securities on the open market. Operations not conducted directly with the central bank, involving private and some state bonds, are settled through the Bond Custody and Financial Clearance Center (CETIP), a system analogous to the SELIC.

D. Institutional and Operational Issues

17. Recently, the President of Brazil issued a decree 8 adopting an inflation targeting framework as the guide for monetary policy. Key points in this decree are:

  • The inflation targets will be established on the basis of variations of a widely known price index;

  • The inflation targets as well as the tolerance intervals will be set by the National Monetary Council on the basis of a proposal by the Minister of Finance;

  • Inflation targets for the years 1999, 2000, and 2001 will be set no later that June 30, 1999; for the year 2002 and subsequent years targets will be set no later than June 30, two years in advance;

  • The Central Bank of Brazil is given the responsibility to implement the policies necessary to achieve the targets;

  • The price index that would be adopted for the purposes of the inflation targeting framework will be chosen by the National Monetary Council on the basis of a proposal presented by the Minister of Finance;

  • The targets will be considered to have been met whenever the observed accumulated inflation during the period January-December of each year (measured on the basis of variations in the price index adopted for these purposes) falls within the tolerance intervals;

  • In case the targets are breached, the President of the Central Bank of Brazil will need to issue an open letter addressed to the Minister of Finance explaining the causes of the breach, the measures to be adopted to ensure that inflation returns to the tolerated levels, and the period of time that will be needed for these measures to have an effect; and

  • The Central Bank of Brazil will issue a quarterly inflation report which will provide information on the performance of the inflation targeting framework, the results of the monetary policy actions, and the perspectives regarding inflation.

18. The national consumer price index IPCA was chosen for the purposes of inflation targeting.9 And specific targets and tolerance intervals for inflation were set as follows:

Targets for Accumulated Inflation During the Year

(In percent)

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E. Challenges Ahead

19. The Brazilian authorities have demonstrated their commitment to low inflation in the last several years. By adopting a formal inflation targeting framework they have reaffirmed their intention to keep it low in the years to come. They have put in place, in a relatively short period of time, a sound framework based on the institutions and operating techniques of countries with a substantial experience with inflation targeting.

20. The Brazilian authorities have decided that monetary policy should give priority to price stability. This is so because, on the one hand, accumulated experience shows that central banks actually have the power to guarantee price stability in the long run. Also, a monetary policy aimed at controlling inflation encourages employment and economic growth. This is a valid objective in view of both the international experience (of developed and emerging economies) and the particular experience of Brazil (which has faced frequent bouts with disruptive high and volatile inflation), both of which show that the costs of inflation are significant and varied. These costs are considerable, and vary not only with the rate of inflation, but also with its volatility.

21. Implementing inflation targeting is not free of considerable challenges. In the first place, there will be a need to deal with the shifting balance of public concerns between inflation and unemployment. Experience in this regard shows that central banks have, at times, been inclined to give considerable weight to the public’s mood regarding the balance between inflation and unemployment. Though an inflation target does not prevent a central bank from implementing policy actions that take into account conditions regarding employment as well as developments in the financial markets, the lessons that have been learned from the experience call for extreme caution. When central banks did not tighten policy early enough to pre-empt inflationary outbursts, inflation usually moved above its previous trend. Restoring inflation to its trend would then require a more aggressive increase in short-term rates, and entail a higher risk of recession.

22. Also, maintaining low inflation requires maintaining a mutual understanding between the markets and the central bank on the reasons behind and the effects of monetary policy actions. If there is a breakdown of this mutual understanding, then the public will not be able to predict what a given policy action imply for the future and, thus, the central bank will not be able to predict how the economy will respond to its policy actions. A central bank that has consistently acted to defend a low inflation objective is likely to have gained enough credibility to maintain this understanding. But a central bank that has not a tradition of aiming at low inflation will be susceptible to a sudden loss of credibility and will usually require some time to restore it. A credible commitment to low inflation is essential for an effective monetary policy.

23. Implementing inflation targeting involves also difficult tactical issues. One such an issue is to determine when pre-emptive policy action is necessary and how aggressive it should be. If the central bank waits until rising inflation becomes a public concern, then it could be too late because inflation will most likely became entrenched in people’s expectations and decisions. On the other hand, poorly timed policy tightening could have adverse effects on employment and output. There is also a need to deal with mistakes. An inflation targeting framework is not free of the possibility of mistakes, because the models on which the projections are based as well as the available information on the economy will always be imperfect. And these are the key elements on which central bankers base their judgement. Central bankers should not be afraid of making mistakes, but they should be accountable for not correcting them as soon as they are identified. Allowing for mistakes to accumulate will allow inflation to move significantly higher and will turn expectations in pricing behavior from a stabilizing anchor into a destabilizing force. Clear procedures have been adopted in Brazil to ensure accountability in this respect.

24. The accumulated experience of other inflation targeting central banks show that there is no need for a central bank to be independent in that it will be free to choose the inflation target. Rather, it appears to be sufficient that the inflation target is legislatively mandated or set by the government, but the central bank is endowed with the authority to choose the necessary policy actions to achieve this target independently of the government. The framework adopted in Brazil is consistent with this approach, but it would be desirable to strengthen instrument independence of the central bank in pursuing its inflation targets through a legislative reform. In particular, it would be important to incorporate into the law: (i) procedures to establish the annual inflation targets; (ii) procedures for the central bank to report to congress on monetary policy and, in particular, on the pursuit of the inflation targets; (iii) fixed terms of office for the president and the directors of the central bank, and appropriate limitations on the types of subsequent employment for departing Board members of the central bank.

25. In addition, this operational independence should be accompanied by increased accountability and by a commitment to keeping the public well informed on how the central bank operates and, particularly, how new information causes the central bank to update its views of future prospects and to modify its policy stance. To a great extent, the quarterly Inflation Report that the Brazilian authorities have begun to publish is expected to play a key role in information and accountability. It would be the vehicle to provide a flow of information that permit the central bank to explain its policy actions and expectations as well as to foster credibility in the monetary policy.


Prepared by Alfredo M. Leone.


Several countries that rely on a consumer price index in specifying their inflation targets have introduced various caveats (or escape clauses) to enable temporary deviations in the event that these are caused by factors beyond the control of the central bank. Substantial increases in indirect taxes, changes in government-controlled prices, and the effects of natural disasters are the most common among such factors.


External, aggregate demand and aggregate supply shocks are seen as the most relevant for Brazil. Given the aggregate nature of the simple structural models, the stylization of the shocks require a careful work to reflect their intensity and timing in the simulations.


The authorities are well aware of the limitations of the estimates and forecasts from these models given that the economy underwent a number of radical structural changes in the last years.


This is known in the literature on inflation targeting as the fan chart approach


Other instruments include reserve requirements, and financial assistance for liquidity. Through the use of its monetary policy instruments, the Central Bank of Brazil influences the availability and cost of the bank reserves, ultimately determining the prevailing credit and monetary conditions of the economy.


Informal auctions are held over the telephone only with the dealers.


Decree No. 3088 of June 21, 1999.


The IPCA survey is made in nine metropolitan areas (Rio de Janeiro, São Paulo, Porto Alegre, Belo Horizonte, Recife, Belem, Fortaleza, Salvador and Curitiba), plus the city of Goiania and the Federal District. It covers families with income between 1 and 40 minimum wages. It is thus considered the broadest consumer price index available, both in geographic terms and in coverage of income ranges.