Credit shocks and monetary policy in Brazil: a structural FAVAR approach

Abstract

This paper investigates the implications of the credit channel of the monetary policy transmission mechanism in the case of Brazil, using a structural FAVAR (SFAVAR) approach. The term structural comes from the estimation strategy, which generates factors that have a clear economic interpretation. The results show that unexpected shocks in the proxies for the external finance premium and the bank balance sheet channel produce large and persistent fluctuations in inflation and economic activity – accounting for more than 30% of the error forecast variance of the latter in a three-year horizon. The Central Bank seems to incorporate developments in credit markets – especially variations in credit spreads – to its reaction function, as impulse-response exercises show the Selic rate declining in response to wider credit spreads and contraction in the volume of new loans. Counterfactual simulations also demonstrate that the credit channel amplified the economic contraction in Brazil during the acute phase of the global financial crisis in the last quarter of 2008, and gave an important impulse to the recovery period that followed through.