Brazil’s Central Bank caught between Delphi and Ulysses
Former Brazilian Central Bank Chief Arminio Fraga will help the Federal Reserve review its communication strategy as part of a task force created by Fed Chair Kevin Warsh to assess the institution’s broader monetary-policy framework. Its conclusions may also prove useful to Brazil’s Central Bank, which has been wrestling with similar questions.
A good starting point for that debate in Brazil is a discussion paper by Fábio Kanczuk, a former director of economic policy at the Central Bank. His view carries particular weight because he was at the helm the only time Brazil reached the lower limit for interest rates, during the pandemic, and had to rely on communication to meet the inflation target.
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Kanczuk sees advantages in telling the market what the Central Bank intends to do in the future, but believes the tool should be used only when investors are mature enough to understand it. Before examining his argument, however, some context is needed.
Communication and rates
A central bank must communicate effectively because it controls only the very short-term interest rate—in Brazil, the benchmark Selic rate. Credit conditions and the broader economy, however, are driven by longer-term rates, which are determined by market forces.
Warsh opposes extensive discussion of future policy intentions. His main criticism is that markets become overly dependent on central-bank signals and less willing to adjust interest rates themselves as economic conditions change.
Broadly speaking, there are two schools of thought.
One favors a more guarded style, epitomized by former Fed Chair Alan Greenspan in the 1990s. He once said that after taking office he had learned to speak with great incoherence.
The other places greater emphasis on communicating future intentions, an approach associated with former Fed Chair Ben Bernanke. During periods of financial crisis, with interest rates close to zero, Bernanke had to become increasingly explicit about keeping rates low to prevent deflation.
Two forms of guidance
Kanczuk argues that the debate is particularly difficult because the term “forward guidance” is used to describe two different tools.
The first follows the analogy of Ulysses, who in the Odyssey asks to be tied to the mast of his ship so that he will not succumb to the sirens’ song. In the same way, a central bank binds itself to a future interest-rate commitment and stays on that course unless a pre-established condition is met, such as inflation or unemployment crossing a certain threshold.
That is precisely what Kanczuk did at the Central Bank in 2020, when further rate cuts were no longer possible without jeopardizing financial stability, even though additional stimulus was needed to meet the inflation target.
With the Selic now at 14.25%, there would be no need for such a tool today.
There is also a Greek analogy for the second type of forward guidance. At times, a central bank speaks like the Oracle of Delphi, sharing its interpretation of the economy and its outlook for the future.
“Delphic guidance is not a mast,” Kanczuk said. “A flight plan can be changed—and should be changed when weather conditions change. The objective is not to promise that the aircraft will fly through a storm simply because the original route said it would.”
Delphic signals
This form of forward guidance is useful for two main reasons.
First, it allows the Central Bank to influence the longer end of the market yield curve and, in turn, credit conditions. Second, it gives investors clues about how policymakers might respond to future developments.
Over the past decade, the Brazilian Central Bank has become far more transparent. It has published its inflation-forecasting models in detail and provided greater insight into its assessment of economic scenarios and the risks ahead.
Some economists believe it has gone so far that it has become trapped by its own transparency.
Kanczuk argues that publishing a forecasting model is not the same as offering forward guidance and therefore does not restrict the Central Bank’s discretion. One feature that is sometimes overlooked is that the model is conditional.
It relies on inputs that are assumptions rather than certainties, including the exchange rate, commodity prices, regulated prices, external conditions and fiscal policy. Policymakers must also decide which shocks are temporary and which are persistent.
The process involves a considerable degree of judgment. The Central Bank must constantly weigh its baseline scenario against numerous alternatives.
“A conditional model does not eliminate discretion,” Kanczuk said. “It organizes discretion.”
Market maturity
For the former Central Bank director, the relevant question is not exactly whether forward guidance is good or bad. It is whether the institution should deepen its use of Delphic guidance.
The answer, he argues, depends on whether the market is mature enough to distinguish between a central bank tying itself to the mast and one merely presenting a flight plan.
When investors fail to understand the difference, the institution’s credibility may suffer.
One curious point, not addressed in the paper, is that the Central Bank under Gabriel Galípolo has recently come under criticism for the opposite reason: the market wanted it to behave like Ulysses when, at most, it could offer only a faded image of Delphi.
