Government Debt and Inflation Targeting in Brazil

The objective of this paper is to understand the Brazilian inflation targeting policy under the flexible exchange rate system. Brazil was in a circumstance so-called "fiscal dominance". For instance, the Brazilian country risk suddenly jumped due to the market perceptions about the presidential election, which led to large capital outflows and exchange rate depreciation in 2002. How did the Brazilian government get along with such a situation in setting the interest rate? We estimated the response function of the Brazilian Central Bank with respect to interest rate setting. We selected the sample period from 2001 to 2003 when the actual inflation rates exceeded the range of inflation targeting. The basic findings are as follows. (1) The Bank sets the interest rate referring to the deviation of the expected inflation and the target rate. (2) The exchange rate (its rate of change) is not statistically significant in determining interest rate. (3) Not only through the channel of exchange rate, the Bank set the interest rate directly responding to the increase in country risk and government debts. When the country risk worsens, interest rate tends to be increased, and on the other hand when the government debts increase, it tends to be reduced. Therefore, it would be appropriate to think at least that, facing to a serious default risk and sustainable government debts particularly in 2001 to 2003, the Brazilian Central Bank flexibly set the interest rate that is deviated to some extent from the basic formula of inflation targeting.