Inflation Targeting in Brazil: Constructing Credibility under Exchange Rate Volatility

This paper assesses the challenges faced by the inflation-targeting regime in Brazil. The confidence crisis in the future performance of the Brazilian economy and the increase in risk aversion in international markets were responsible for a sudden stop of capital inflows in 2002 that caused a significant depreciation of the exchange rate. The inflation-targeting framework has played a critical role in macroeconomic stabilization. We stress two important challenges: construction of credibility and exchange rate volatility. The estimations indicate the following results: i) the inflation targets have worked as an important coordinator of expectations; ii) the Central Bank has reacted strongly to inflation expectations; iii) there has been a reduction in the degree of inflation persistence; and iv) the exchange rate pass-through for "administered or monitored" prices is two times higher than for "market" prices.