The Brazilian Central Bank works with inflation targeting, which determines maximum and minimum values for annual inflation, increasing or decreasing the base interest rate in order to keep inflation within this range and as close as possible to the target. Since 1999, the bank has almost always done well at this task, and its success can be measured by credibility indicators. Accordingly, a new study by Professor João V. Issler of the Brazilian School of Economics and Finance (FGV EPGE), titled “A short-term credibility index for central banks under inflation targeting: An application to Brazil,” proposes a “warning system” that every month calculates the probability of inflation staying within the target range in the near future (in the next six months).

The idea is that more frequent monitoring of this kind can avoid some distortions. For example, in the current modus operandi, December’s inflation is compared to the target, and it may remain within the target range even if it is outside the acceptable limits for a few months or falls outside them in subsequent months. The proposal presented in this article would allow the bank to react more efficiently if there is an indication that inflation will leave the target range.

The paper also measures the Brazilian Central Bank’s credibility, focusing on the short term, complementing the usual long-term measurements mentioned in the literature. Traditionally, estimates of credibility are based on people’s expectations of the bank’s ability to keep inflation on target. Consequently, computing this variable is a delicate task, given the need to model human behavior. In the proposal presented, short-term credibility is based solely on the inflationary process itself.

The paper was written in collaboration with two economists at the Maastricht University School of Business and Economics in the Netherlands. To read the full study, click here.