The monetary policy gap

In a recent post, Fabio has discussed the nominal neutral interest rate in Brazil. According to him, this rate is somewhere around 11%, which means that monetary policy (MP) will get into neutral mode in the next one or two Copom´s meeting.

Based on one of the mainly BCB´s model (Samba), I got almost the same conclusion. In my exercise, I consider that, until the end of 2014, MP will target CPI at 5.5% (against the official target of 4.5%). After that, the target will smoothly converge to 4.5% in 2016. In Samba, MP evolves according to a traditional Taylor Rule, where interest rate is a function of output gap, expected inflation and the CPI target, besides its own lags and an error component (monetary shock).

Figure 1 shows observed interest rate (blue line) and a counterfactual rate that would prevail in a world where MP never deviates from Taylor Rule (dashed red line). The difference between both rates (illustrated by the green area) is what I call “monetary policy gap”, a measure that shows us if MP is on a dove or on a hawk mode (in relation to its historical behavior).

As we can see, after a very short cycle of tightening, BCB acted in an unprecedented dovish way (even taking into account all the headwinds from world economy, as the model does!). The good news is that, after seven consecutive hikes, the gap has closed in 4Q13. And comparing Samba´s projections with consensus forecast, monetary policy gap will be kept around zero until the end of 2014 (both project selic around 11.25%).

In other words, MP will not put more pressure on inflation. So, in that sense, it´s possible to say that it has become neutral. Unfortunately, this doesn´t mean that BCB´s dovish bet in the last years will have no consequences from now on. As the central bankers love to emphasize, MP works with lags, which means that the dovish adventure will impact CPI over this year. And, according to Samba, this impact is far from trivial: after accounted for 2.1 p.p of CPI in 2013, it will account for almost a full percentage point of inflation in 2014.

BCB will face two options. The first one is to became even hawker, and put monetary policy gap on positive territory. The second (and my favorite one) is to keep MP as neutral as it is today and pray against adverse shocks. I believe Tombini will give us a hint of his possible choice tomorrow.