Elusive Unpleasantness

As first argued in Sargent and Wallace (1981), under certain conditions a tighter monetary policy today might give rise to higher expected inflation if the public perceives that the worsened debt dynamics could end up in debt monetization. This channel is arguably stronger in countries featuring high debt and interest rates, along with weaker economic institutions. Brazil is a large emerging economy that fits the profile. Yet, using a high-frequency identification strategy, we show that higher interest rates lead to unequivocally lower inflation expectations (and local currency appreciation) around Brazilˆas Central Bank monetary policy meetings