Estimating the credibility of Brazilian monetary policy using a Kalman filter approach

Abstract

The objective of this study is to estimate the credibility of the monetary policy followed by the Central Bank of Brazil (BCB) during the period 2006–2015. To estimate this credibility, we use the Kalman filter in three measures of inflation expectation: two collected via market survey and via consumer polling, as well as the breakeven inflation. The results provide evidence of the existence of three shifts in the perceived credibility of BCB inflation targets during the period analyzed: (i) credibility declined sharply in mid-2008, at the most critical moment of the subprime mortgage crisis; (ii) credibility was relatively stable from early 2009 through mid-2013; (iii) credibility trended downward thereafter, when the real interest rate was less than the minimum rate compatible with the inflation target. By associating the estimated credibility with macroeconomic and financial variables, we find a downward trend in credibility during recessionary periods and an inverse relationship between credibility and output gap, between credibility and variation in the BRL/USD exchange rate, and between credibility and historical inflation. In addition, we find that market survey and breakeven inflation credibility measures are important in predicting sovereign risk. Furthermore, changes in the inflation rate are important for predicting only credibility measured on consumer polling, validating the assumption that measures from consumer polls are backward-looking and formed based on consumers’ adaptive expectations.