Question : Would you recommend that Tombini continue to raise interest rates? Why or why not?

Alexandre Tombini was worried. When he took over as governor of the Central Bank of Brazil in 2011, he had committed to an inflation target of 4.5%.1 Now, in July 2015, inflation exceeded 10% per year, well above his target (Exhibit 1). Under more usual circumstances, he could raise interest rates to slow down the economy and rein in inflation. The situation in mid-2015 was especially tricky, however, because the economy was experiencing stagflation: both high inflation and exceptionally high unemployment (Exhibit 1). Any policy actions that slowed inflation were likely, at least in the short term, to cause even higher unemployment.

Brazilians were already upset with high unemployment and negative GDP growth (Exhibit 2). To complicate the situation further, President Dilma Roussef was facing calls for her impeachment because of allegations of her involvement in corruption at the state-run oil company Petrobras.2 It seemed that Brazilians from across the socioeconomic spectrum had reason to be angry: those who were unemployed were upset by the lack of opportunity and income; those with more secure jobs were upset by perceptions of government incompetence and corruption.

How quickly the trajectory of Brazil's economy seemed to have changed since Tombini started his term. He had been appointed governor of the Central Bank by Roussef soon after she was elected in 2010. Roussef was a protege of the popular previous president and founder of the Worker's Party, Luiz Inacio Lula de Silva (Lula). Lula's economic policies, which included investment in infrastructure through public-private partnerships and simplification of the tax code, were perceived as generally successful.3 During Lula's two terms in office, living standards improved substantially: real GDP per capita increased by over 2.85% per year, compared to 0.9% during the eight years prior to his presidential terms (

Exhibit 2

), and the fraction of the population living on less than $3.10 a day fell from 10.0% to 5.45%.4

Upon taking office in 2011, Tombini expected that he would be able to maintain stable inflation while the economy grew at a positive and steady rate. Brazil's GDP growth had rebounded from the global financial crisis of 2008 after a short stint in negative territory (

Exhibit 2). Following the global financial crisis, the economy had seemed to resume its upward trajectory, and Tombini expected the trend to continue.

There was, however, always a worry in Tombini's mind that he could face difficult policy tradeoffs. He worried not only that scenarios could emerge that would force him to choose between high inflation and high

Paulo Trevisani, "Brazil's Tombini Reinforces Inflation-Target Pledge," Wall Street Journal, September 15, 2015, https://www.wsj.com/articles/brazils-tombini-reinforces-inflation-target-pledge-1442330701 (accessed Sept. 21, 2017).

2 "Brazilian Protestors Call for Dilma Rouseff's Impeachment," BBC News, August 17, 2015, http://www.bbc.com/news/world-us-canada- 33953606 (accessed Sept. 21, 2017).

3 Juan Forero, "Brazilian President's Handpicked Successor Leads, Faces Runoff," Washington Post, October 4, 2010. 4 Source: World Databank.

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unemployment, but also that his job security depended on the approval of Roussef. Unlike his counterparts at many central banks in advanced economies, the governor of the Central Bank of Brazil could be fired at any time by the country's president.5 And Tombini was well aware of the pressure facing Roussef to increase employment, especially close to the elections, even if the policies required to do so stoked the flames of inflation. Tombini would almost certainly feel pressure (explicit or implicit) to accommodate inflation with low interest rates if unemployment were to become a political concern for Roussef.

Despite these apprehensions, Tombini never expected the situation to become as dire as it now appeared in mid-2015. Many of the underlying factors behind stagflation were due to forces outside his control. The plummeting value of the Brazilian real (Exhibit 3) was causing a spike in import costs. Similar to the oil-price shock of the 1970s that was perceived as contributing to stagflation in the United States at the time, the devaluation in Brazil increased costs and ultimately consumer prices (Exhibits 3 and 4). Government budget deficits were increasing, and many international investors who lent money to Brazil worried that the Central Bank would maintain low interest rates in order to lower government borrowing costs.6 Given the lack of independence between Tombini's Central Bank and Brazil's executive branch, these concerns were not without merit.

Tombini did indeed raise interest rates as inflation increased in early 2015 (Exhibit 4), which contributed to the increase in unemployment. As of July, it was unclear whether further rate rises were necessary. Interest rates were merely increasing at the same rate as inflation, and it seemed that a more aggressive response from the Central Bank was necessary to bring inflation back in line with its target.

The Roussef administration, to which Tombini owed his job, was under intense pressure to make immediate improvements in employment and economic growth. Roussef's government was pursuing expansionary fiscal policy (Exhibit 5), adding to government debt at an alarming rate (Exhibit 6) and potentially stoking the inflationary pressure that Tombini hoped to control. The increase in interest rates necessary to maintain the inflation target would almost certainly further accelerate the economic slowdown.

But the short-term benefit of maintaining low interest rates bore the cost of double-digit inflation and, more worrisome, rising inflation expectations (Exhibit 7). The public had inferred, both from recent inflation and from Tombini's reluctance to stick to his inflation commitment that high inflation was likely to continue. In order to bring inflation expectations (and hence inflation) back in line with his target, Tombini would need to raise rates significantly. In doing so he would likely plunge the economy deeper into recession.

The only other option seemed to be the hope that factors outside Tombini's control would put downward pressure on costs and inflation. Brazil was notorious for its high costs of doing business (see Exhibit 8 for costs of doing business in Brazil relative to other countries). If the government could cut red tape and lower costs for businesses, those cost reductions would be passed on to consumers and hence reduce inflation. Given the entrenched bureaucracy and the time that it generally takes for such large reforms to take effect, Tombini did not have time to hope and wait for reform-induced cost reductions.

There were no good options left for Tombini as of mid-2015. Should he continue to accommodate inflationary pressure, hoping that it would somehow subside on its own? He knew from past history, including the experience with stagflation in the United States, that inflationary pressures typically continue to build rather than subside once inflation expectations begin to rise. Alternatively, he could aggressively combat inflation. But

5 Joe Leahy and Samantha Pearson, "Brazil to Formally Enshrine Central Bank's Autonomy," Financial Times, July 12, 2016, https://www.ft.com/content/ff464df6-4895-11e6-ab7c-840b4062e27c (accessed Sept. 21, 2017).

6 Kenneth Rapoza, "Why Brazil Keeps Raising Rates," Forbes, June 4, 2015, https://www.forbes.com/sites/kenrapoza/2015/06/04/why-brazil- keeps-raising-rates/#2d2a46333bd6 (accessed Sept. 21, 2017).

if he did so, could he maintain his hold on the reins of the Central Bank? The Roussef administration was embattled and needed every bit of short-term stimulus it could muster to appease the growing number of citizens on the brink of unemployment. The choice was not easy.

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UVA-GEM-0145

*Note: Shaded areas depict Brazil's recessions.

Exhibit 2

Brazilian Stagflation

Real GDP Growth*

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UVA-GEM-0145

DardenBusinessPublishing:253871

Exhibit 3

Brazilian Stagflation

Inflation and Exchange Rate

Exhibit 4

Brazilian Stagflation

Inflation and Monetary Policy Rate

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Exhibit 5

Brazilian Stagflation

Exhibit 6

Brazilian Stagflation

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Ease of doing business index (1=most business-friendly regulations)

Cost of business start-up procedures (% of GNI per capita)

Start-up procedures to register a business (number)

Time required to start a business (days)

UVA-GEM-0145

Exhibit 8

Brazilian Stagflation

Ease of Doing Business, 2015

Table 1: Ease of Doing Business, 2015

Brazil China India United States

Mean Median

116 84 130 7 95.4 95.5 1 189

3.8 0.7 13.5 1.1

11 11 12.9 6

83 31.4 29 5.6

26.2 10.9 0 330.1

6.9 7 1 18

20.5 13 0.5 144

Min Max