Inflation Targeting and Debt: Lessons from Brazil

We study the recent experience of Brazil to understand how default riskis at the centre of the mechanism through which a central bank that targets inflation might lose control of inflation—in other words of the mechanism through which the economy might move from a regime of "monetary dominance" to one of "fiscal dominance". The literature, from Sargent and Wallace (1981) to the modern fiscal theory of the price level has discussed how an unsustainable fiscal policy may hinder the effectiveness of monetary policy, to the point that an increase in interest rates can have a perverse effect on inflation. We have shown (consistently with the findings of Blancahrd in this volume) that the presence of default risk reinforces the possibility that a vicious circle might arise, making the fiscal constraint on monetary policy more stringent. In the experience of Brazil we believe we have identified an interesting episode where this might have happened, at least for a short period during 2002. But the episode also shows how critical the behavior of fiscal policy is. Brazil, during 2002, had probably fallen into a bad equilibrium, where fiscal policy was hindering the effectiveness of monetary policy. But the economy was just over the edge: a small change in the fiscal rule, such as that announced by the Lula government in January 2003, was enough to bring the economy back to normal conditions, and rapidly reduce the Embi spread, stabilize the exchange rate and, through these two variables, inflation expectations, inflation and the dynamics of the public deb