Radar Perene / Archive / science

Inflation and indexation: the memory contracts keep

◦ Index methodology v2.2 (working papers with DOI). See the methodology.

Science

In early 2021, millions of Brazilian tenants received a similar letter: the rent would be adjusted by the index written into the contract, and the index written into the contract had accumulated more than twenty percent in twelve months — in a year when consumer inflation had barely passed four. Nobody had miscalculated. The contract simply did what indexed contracts do: it remembered the past with implacable precision, even though the past it remembered belonged to a basket the tenant did not consume.

Indexation is the clause that ties a future value — rent, tariff, wage, debt — to the past variation of a price index. It protects each individual contract against inflation's erosion; at scale, however, it transmits yesterday's inflation into tomorrow's prices. Brazilian literature knows both sides of that coin better than any other, because it lived them.

Brazil did not invent indexation, but it took it further than almost any economy. Understanding what the research shows about it is understanding why certain prices in the country seem to have memory — and why that memory was, at a decisive moment in history, the enemy to be disarmed.

Where the habit came from

Brazil's formal indexation was born as a remedy: the monetary correction of the 1960s allowed savings, taxes and government bonds to coexist with high inflation without collapsing. The remedy worked — and became a habit. Over the following decades, wages, rents, tariffs and contracts came to look backwards by clause.

It was on that landscape that the literature of inertial inflation was built in the 1980s: Brazilian economists argued that much of the period's inflation no longer came from excess demand or fresh shocks, but from the automatic replacement of past inflation — each contract restored the previous increase, and the sum of the restorations manufactured the next one. Inflation stayed alive because the contracts remembered it.

The most dramatic test of that thesis was the Plano Real. The URV, in 1994, was essentially a piece of de-indexation engineering: a transitional unit of account that synchronized prices before the new currency, breaking the chain of restorations without a price freeze. The plan's success is the strongest empirical argument ever produced in favor of the inertial diagnosis — what was disarmed was not demand, but memory.

What the research shows under inflation targeting

Brazil has operated under inflation targeting since 1999, and indexation did not disappear — it was tamed. Legislation came to require a minimum annual frequency for contractual adjustments; part of public tariffs remains indexed by rule; the minimum wage, rents and various long-term contracts still look at past indices.

The targeting-regime literature treats this inheritance under the name of inflation persistence: the larger the fraction of the economy that restores past inflation by clause, the slower inflation yields when conditions change, and the more costly — in interest rates and in activity — convergence to the target becomes. The finding is descriptive and repeated in studies by the Central Bank itself and by academia: indexation protects the contracting party and burdens disinflation. There is no one-sided version of this coin.

The episode that reopened the debate

The 2020-2021 rent case deserves the record in numbers, because it is the perfect example that "inflation" does not exist in the singular. In numbers: the IGP-M, the traditional index of rent contracts, accumulated 23.14% in 2020, while the IPCA — the inflation of the household consumption basket — closed the same year at 4.52%. The distance between the two was no measurement error: the IGP-M carries heavy weight from wholesale prices and the exchange rate, and 2020 was a year of pressured currency. Two honest indices, two different baskets, one contract that could see only one of them.

The house treats these series with the same open-data discipline described in open data from the Central Bank: index identified by code, source stamped, value verifiable by any reader. And the archive keeps the record of the cycle in which inflation returned to the table after the pandemic — mid-2021, when inflation returns — reread today as a chapter in which indexed contracts and current prices went back to arguing over which past should count.

What remains of the discussion

The question "is indexation good or bad?" has no scientific answer, because it mixes two questions with documented answers. For the individual contract, indexation transfers inflation risk from one party to the other — whoever receives the indexed value is protected; whoever pays, exposed. For the aggregate economy, widespread indexation extends the life of inflation that has already happened. Brazilian data sustains both sentences at once, and that is exactly why the theme returns with every cycle of rising prices — with the same arguments, because both sides have literature.

Frequently asked questions

Does indexation cause inflation?

It does not originate it; it propagates it. Brazil's inertial diagnosis of the 1980s is the classic case: old shocks stayed alive because contracts kept restoring them. Indexation is a transmission mechanism, not an ignition.

Why do rents use the IGP-M and not the IPCA?

By contractual tradition consolidated over decades, not by legal imposition — parties may agree on another index. The 2020-2021 episode, when the two indices drifted apart to an extreme, led part of the market to renegotiate that tradition.

What was the URV, in one sentence?

A transitional unit of account that, in 1994, synchronized the economy's prices before the currency change — the piece of engineering that de-indexed the system without freezing prices.

Is one inflation index "more correct" than another?

Each index answers a question: the IPCA, about the household consumption basket; the IGP-M, about a composition with wholesale prices and the exchange rate; the INPC, about lower-income households. The documentable error is not choosing an index — it is using one of them to answer another one's question.

From prices that look backwards, the trail moves to the country's most folkloric price — and to the century-old ruler that separates data from opinion in exchange rates: purchasing power parity →

House readings: each day's price indices are in today's note, in the Daily; the cycles when inflation changed chapters, in the precedents, in the Atlas.

Comparing deflators and clauses of a specific contract is the kind of exercise the house conducts on request.