Brazil’s post-modern central bank
Emerging markets central banks are moving away from using rate changes solely to control inflation. Brazil seems to have joined the trend.
The real has lost 17% of its value since early September after Brazil’s central bank took the markets by surprise and cut the Selic rate by 50 basis points. Despite inflation, at 7.34%, remaining much higher than its target of 4.5% plus or minus two percentage points, the bank lowered the base rate to 12%. The real fell against the dollar, going below $1.90 before recovering a little. However, at the end of September it was still trading at levels last seen early in 2010.
There were other factors that strengthened the dollar against emerging market currencies. However, no other emerging market currency has fallen against the dollar as much as the real and there is a consensus in São Paulo that the abrupt reversal in monetary policy led to the real falling faster and further than the central bank planned, and probably wanted.
One banker told Euromoney that now the "tide had gone out, we will now see who is dead on the beach" – a variant on the standard "when the tide goes out we will see who is swimming naked".
Although there are, as yet, no suggestions that the exchange rate movement will lead to large derivatives losses, as was the case in 2008, there will be losers (as well as winners) from the large and rapid dive in the value of the real. There is some concern – and perhaps also a little anger – that the central bank exacerbated the large movement in the real by failing to signal a change in its approach.
"While I understand that the central bank doesn’t have any responsibility to make markets money, I don’t understand how they can just change their view on monetary policy like that," said a São Paulo-based banker, who presumably got caught on the wrong side of a dollar/real trade. "I can do that – I can change my view every day. And the way they handled the interest rate announcement definitely affected the FX."
But although the interest rate cut was a surprise, perhaps it shouldn’t have been. Analysts have for some time been saying that the old monetary imperative of inflation targeting has become outdated for emerging market economies.
Nomura has been talking about the creation of "post-modern" central bank policies since the beginning of 2011, and it has recently published research that shows that there is no correlation between real interest rates and inflation in emerging market economies. Good examples of this post-modernist approach are Turkey and Hungary, which have for some time considered a wider range of data than inflation: they assess current account and credit growth and also target them with different policy instruments than just base interest rate policy.
Central banks in emerging markets will increasingly use a bigger box of tools and target a wider set of economic measures. Inflation will still be important, of course, but where previously inflation targeting was the sole factor, central banks now take a much more flexible approach and also concentrate on growth and macro-prudential features such as financial stability, risk premia, currency and credit growth. And Brazil seems to be showing that post-modern central bank policy is now being adopted in Latin America.