The perils of Penelope

BRAZIL ECONOMICS - Report 18 Feb 2025 by Alexandre Schwartsman, Cristina Pinotti and Diego Brandao

Copom’s current balance of risks highlights the asymmetry toward upside inflation risks, including economic overheating, given the positive output gap—one of the fundamentals of the current interest rate hike cycle. Economic slowdown and the consequent reduction of the output gap, thus reducing inflation, depend on a decline in household consumption, the main driver of domestic demand expansion. In this context, as stated by the Central Bank in the minutes of its last meeting, the credit channel is of particular importance, as it played a central role in sustaining consumption and aggregate demand last year.

Here, we examine the role of credit in driving consumption expansion as a transmission mechanism of monetary policy, presenting evidence of its impact on demand. In this regard, we also highlight a recent study by the Central Bank that underscores the effect of variations in the Selic rate on credit concessions.

Finally, we analyze government initiatives in this area. The Copom, in its latest minutes, emphasizes that the effectiveness of monetary policy—i.e., reducing inflation with the lowest possible interest rate—depends on the transmission channels of monetary policy being unobstructed. However, moving in the opposite direction of this proposition, the government is signaling measures to expand the supply of credit, either by boosting private payroll loans or through the actions of public banks. This intensifies the conflict between the Central Bank and the Executive, leading to two possible outcomes: either the Central Bank will have to raise interest rates even further to achieve the same inflation rate, or it will have to accept higher inflation for a given interest rate.

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