The main objective of this paper is to estimate a Central Bank reaction function that accounts for the effects of directors’ rotation of the Brazilian COPOM (Monetary Policy Committee). The reaction function proposed is assumed to be the mechanism for inflation targeting policy. It accounts for the COPOM rotation to examine COPOM's policy credibility. The empirical analysis use monthly data from 2001 to 2008 to estimate a structural vector auto-regression (SVAR) in order to learn about the long run effects. The SVAR results suggest that the turnover of the COPOM board of directors affects inflation expectation and interest rate of the Brazilian economy in the long run. This means that the turnover causes economic agents to increase their expectations about inflation, resulting in increases of the rate of change of the interest rate level. This break in credibility leads to an additional cost to society through higher future interest rates to be paid by government bonds.
Since July 1999, Brazil has adopted inflation targeting as its monetary policy regime. This policy uses the nominal interest rate as a mechanism to affect real and nominal economic variables. The COPOM (Monetary Policy Committee) focuses on nominal interest rate to control future expectations about inflation and, thus, achieve price stability and control inflation. By announcing its inflation target range, they believe that the interest rate policy will not cause expectations to go wild and, thus, lose control of the inflation target. This mechanism of controlling expectations, in our view, depends upon COPOM members’ permanence in their positions in order for the monetary policy to have credibility. The replacement of COPOM members may lead economic agents to see as a weakening of the inflation target policy1 and, thus, inflation may not converge to the expected rate proposed by the previous COPOM members.
This paper examines this proposition by verifying the importance of COPOM directors’ turnover for inflation target policy. This paper also investigates the role played by variables like output gap, inflation target level, rate of change in inflation, and output gap expectations for the inflation target policy in Brazil. The empirical analysis brings as innovation the use of SVAR-Structural Vector Auto Regression, which is a technique that is able to account for causality.
The COPOM inflation target policy follows a theoretical model known as dynamic stochastic general equilibrium (DSGE). This model is based on Gali (2008) and Woodford (2008), as well as the contributions made by Goodfriend and King (1997), McCallum, 1999, McCallum, 2001 and McCallum, 2005, Clarida et al. (1999), Meyer (2001) and Goodfriend, 2004 and Goodfriend, 2005. The model contains a reaction function that supposedly combines key macroeconomic variables that enables policy makers to set interest rate level. This paper focuses on this reaction function by adapting it to consider the turnover of COPOM members.
In addition to this introduction, the paper is divided into six sections: Section 2 is the theoretical framework; Section 3 exhibits some empirical evidence on the estimation of the reaction functions; Section 4 presents the empirical methodology; Section 5 discusses the econometric results; and, finally, Section 6 outlines final considerations.
This paper discusses the current conduct of monetary policy adopted in Brazil within the context of the new macroeconomic consensus. We propose a reaction function that accounts for COPOM's credibility. The change in the COPOM directors is used to measure the long run credibility of the Brazilian Central Bank monetary policy. The equation system is estimated using the SVAR methodology to obtain long run coefficients.
The overall results of our proposed model indicate that COPOM directors’ rate of change seems to influence the expected deviation of output gap, expected inflation and by extension the rate of change of the interest rate. The estimated effect is positive, indicating that the turnover increases the deviation of output from its potential level and brings together inflation rate above or closer to the expected rate, both conditions require increases in the rate of change or acceleration of interest rate increases. More precisely, changes in COPOM's directors occurred in the period have not contributed for price stability. The main long run outcome is further increases in interest rate. This result indicates that the change of COPOM directors affected the Brazilian Central Bank policy credibility with economic agents. In sum, directors’ changes had a social cost through the payment of higher government bond's interest rate.
How to overcome the turnover problem? According to Rogoff (1985), the board of directors must have a formal contract that guarantees their compromise with price stability and acting independence. Hence, society should perceive them as independent from any government institution, otherwise the COPOM itself as institution will not have the desired credibility.
