Specification errors, nonlinearities, and structural breaks in the Central Bank of Brazil’s reaction function

In this paper, we investigate nonlinearities in the Central Bank of Brazil (BCB)’s reaction function that may be associated with uncertainties over potential output and effects of the output gap on inflation. We perform structural break tests to assess possible changes in the conduct of the monetary policy and estimate nonlinear reaction functions by instrumental variables (IV) and identification-robust methods. Our results indicate a stronger reaction of the Selic rate to inflation and output gaps during periods in which the BCB was chaired by Henrique Meirelles. These changes can be associated with the observed increase in the BCB’s preference for inflation stabilization in relation to interest rate stabilization. We also found empirical evidence that points to the non-identification of the parameter that measures BCB’s concern in designing a robust monetary policy to specification errors. Finally, we observed that the introduction of smoothing terms in the BCB’s reaction function impaired the identification of all coefficients.