Whereas the market has always expected with some degree of uncertainty the Copom (Brazilian monetary authority) decision on interest rates, this time the noise is greater than ever. This is so because of a significant change in domestic and external events since the last Copom meeting held in early September. To understand the reasons as to why the Copom has plenty of room (and economic reasoning) to decrease rates in the last two meetings of 2007, we provide a brief overview of the past events on the domestic and external front that may influence the Copom decision
1. Domestic Scenario: Overview
There is no market consensus on the upcoming Copom meeting next week. Indeed, markets have been very volatile since the last decision (delivered by early September). Then, the committee decided unanimously to reduce the speed of cut from 50 bps to 25 bps as a response to the international financial markets turmoil, the deteriorations in market expectations and, the BRL depreciation (BRL1.953/USD in Sep-5th). Right after the meeting came a spike on the August IPCA (+0.47%, up from 0.24% in July), increasing jitters over an inflationary surge in Brazil, instigated by the high services IPCA reading (+0.48%). Such fact fostered some analysts to argue that the economy was suffering from an acute overheating, and aggregate supply would not match the fast-growing aggregate demand. Analysts were basically divided between those who saw higher inflation merely as a result of a temporary supply-side shock coming mainly from food prices increase and those who argued it was actually a demand-side shock that would probably last longer than expected.
To make matters worse, the BCB released the last Copom minutes with a very hawkish tone. When referring to its inflation forecasting models, the BCB said the reference scenario projection for 2007 was ‘remarkably’ higher than the results obtained on the immediately previous meeting and ‘sensibly’ higher for the 2008 projection. At the same time, the market scenario recorded stable forecasts for 2007 and lower projection for 2008. Aside from the tone, the results were showing that the forecasts were probably overestimating inflation.
In the meantime, the BRL continued to recover, reaching BRL1.875/USD on Sep-18th. In the same day the US Federal Reserve surprised the market and cut the Fed Funds rate by 50 bps. The Fed decision certainly improved expectations and contributed to a decrease in risk aversion. In Brazil, the Fed decision was reflected by a stock market boom and a strengthen in the BRL. The release of mid-month IPCA-15 (a good forecast for the IPCA) for September came much lower than expected and reached 0.29% in September from 0.42% in August. In brief, the IPCA-15 suggested that the inflationary pressures in July and August were temporary and basically caused by food as well as some isolated increases in scatter items.
Following the positive inflation reading came the BCB’s quarterly inflation report. The document brought a much more dovish tone than we were expecting, way different from the tone of the latest COPOM minutes.
The reference scenario, which assumes the Selic rate and the FX rate will remain flat at levels back then, in this case 11.25% and BRL1.950/USD respectively, brought a forecast of 4.0% for 2007, up from 3.5% in the previous report, while for 2008, the forecast increased from 4.1% to 4.2%. Contributing to the higher projected values was the momentum inherited from the higher actual inflation.
The market scenario projection took into account a projected Selic rate of 11.05% and 10.17% for the end of 2007 and 2008 respectively, above the projected 10.98% and 10.0% used on the previous inflation report. The FX rate assumptions were also different. For 2007 it went from BRL1.950/USD to BRL1.900/USD while for 2008 it went from BRL2.040/USD to BRL1.950/USD. As a result, the projected IPCA for 2007 increased from 3.5% to 3.9% at the same time that the projection for 2008 slid from 4.6% to 4.3%. Therefore, model was projecting lower 2008 inflation and within the established target, even though the inflation for 2007 was expected to be slightly higher.
Nonetheless, overall expectation continued to improve and the BRL, a key variable on the BCB’s decision-making continued to appreciate closing Oct-9th at BRL1.801/USD. The day after, the IBGE released the full-month September IPCA figure, which surprised analysts once again printing a much lower than consensus +0.18%. Not only was food inflation much lower but also services IPCA slid from +0.48% in August to +0.20%. The lower IPCA is a strong element to refute the idea that the Brazilian economy was suffering from a demand-side shock.
Market conditions have significantly improved since the release of the quarterly inflation report. Moreover, worries about the pass-through from food to services have somewhat vanished as the likelihood of a generalized ‘contamination’ is very low. Looking ahead, we see a significant chance of a 25 bps on the coming meeting (Oct-17th) and, we would not discard another rate cut on the Deceber-5th meeting. The CB has already started FX interventions as the monetary authority has an open capital account and hence has chosen to bear nominal appreciation at the expense of lower inflation.
The question that we have stressed in previous analysis is the need for Brazil to cut rates more vigorously. In this situation, there would be a decrease in the risk premium and possibly a decrease in capital inflows. In turn, the monetary authority would not need to promote constant sterilization policies that end up increasing the fiscal service (or quasi fiscal) of the debt.
2. External Scenario: Overview
The latest World Economic Outlook argues that the world is experiencing longer periods of economic growth and shorter phases of recession. The question that the BCB has to take into account is: What are the impacts in Brazil of a US slowdown?
The answer to the above question has to take into account two scenarios:
1) No decoupling (ND)
2) Decoupling (D)
In the ND scenario the subprime crisis drives the US to a mild recession (soft landing). In this case, the decreasing in rates by the Fed will not prevent the slowdown in domestic consumption and production. In the ND situation, there is a slowdown in the key developed markets that are transmitted through trade and financial channels to emerging markets like Brazil. In this case, a slowdown in the developed world implies a decrease in US imports from China (and from Brazil). China, in turn, would decrease its imports from Brazil. Commodity prices would go down and hence, Brazilian exports would decrease. In turn, Brazilian current account would diminish leading to lower growth of output. On the financial side, lower interest rates in the US (and lower commodity prices) would induce a capital outflow from Brazil (flight to quality) leading to a depreciation of the BRL and an upward inflationary pressure.
In the decoupling (D) scenario, China and Europe would decouple from the US slowdown. In turn, commodity prices would not go down because Europe would absorb more exports from Asia in general and China, in particular. Brazilian exports would not be significantly affected and hence the impact in output would be minor. On the financial side, the weakening of the USD would continue, leading investors to leave the US in search for higher yields. In turn, capital inflows to Brazil would continue in the current levels and thus, the slowdown would be restricted to the US with few impacts in other countries.
3. Conclusion
In the traditional scenario (US slowdown without decoupling), the Brazilian Central Bank possibly would stop decreasing rates. The monetary authority would observe the amount of capital outflow, decrease in reserves and mostly the eventual inflationary impacts triggered by a depreciating currency. In the decoupling scenario, the Brazilian monetary authority would keep decreasing rates, mostly because the US slowdown would be isolated episode and the whole developed world would be registering positive growth rates.
In the absence of inflationary pressures in the domestic side and considering that the leading world economies have not displayed recessionary signs we believe that there is room for further easing. We invite you to give your opinion on this issue.
1. Domestic Scenario: Overview
There is no market consensus on the upcoming Copom meeting next week. Indeed, markets have been very volatile since the last decision (delivered by early September). Then, the committee decided unanimously to reduce the speed of cut from 50 bps to 25 bps as a response to the international financial markets turmoil, the deteriorations in market expectations and, the BRL depreciation (BRL1.953/USD in Sep-5th). Right after the meeting came a spike on the August IPCA (+0.47%, up from 0.24% in July), increasing jitters over an inflationary surge in Brazil, instigated by the high services IPCA reading (+0.48%). Such fact fostered some analysts to argue that the economy was suffering from an acute overheating, and aggregate supply would not match the fast-growing aggregate demand. Analysts were basically divided between those who saw higher inflation merely as a result of a temporary supply-side shock coming mainly from food prices increase and those who argued it was actually a demand-side shock that would probably last longer than expected.
To make matters worse, the BCB released the last Copom minutes with a very hawkish tone. When referring to its inflation forecasting models, the BCB said the reference scenario projection for 2007 was ‘remarkably’ higher than the results obtained on the immediately previous meeting and ‘sensibly’ higher for the 2008 projection. At the same time, the market scenario recorded stable forecasts for 2007 and lower projection for 2008. Aside from the tone, the results were showing that the forecasts were probably overestimating inflation.
In the meantime, the BRL continued to recover, reaching BRL1.875/USD on Sep-18th. In the same day the US Federal Reserve surprised the market and cut the Fed Funds rate by 50 bps. The Fed decision certainly improved expectations and contributed to a decrease in risk aversion. In Brazil, the Fed decision was reflected by a stock market boom and a strengthen in the BRL. The release of mid-month IPCA-15 (a good forecast for the IPCA) for September came much lower than expected and reached 0.29% in September from 0.42% in August. In brief, the IPCA-15 suggested that the inflationary pressures in July and August were temporary and basically caused by food as well as some isolated increases in scatter items.
Following the positive inflation reading came the BCB’s quarterly inflation report. The document brought a much more dovish tone than we were expecting, way different from the tone of the latest COPOM minutes.
The reference scenario, which assumes the Selic rate and the FX rate will remain flat at levels back then, in this case 11.25% and BRL1.950/USD respectively, brought a forecast of 4.0% for 2007, up from 3.5% in the previous report, while for 2008, the forecast increased from 4.1% to 4.2%. Contributing to the higher projected values was the momentum inherited from the higher actual inflation.
The market scenario projection took into account a projected Selic rate of 11.05% and 10.17% for the end of 2007 and 2008 respectively, above the projected 10.98% and 10.0% used on the previous inflation report. The FX rate assumptions were also different. For 2007 it went from BRL1.950/USD to BRL1.900/USD while for 2008 it went from BRL2.040/USD to BRL1.950/USD. As a result, the projected IPCA for 2007 increased from 3.5% to 3.9% at the same time that the projection for 2008 slid from 4.6% to 4.3%. Therefore, model was projecting lower 2008 inflation and within the established target, even though the inflation for 2007 was expected to be slightly higher.
Nonetheless, overall expectation continued to improve and the BRL, a key variable on the BCB’s decision-making continued to appreciate closing Oct-9th at BRL1.801/USD. The day after, the IBGE released the full-month September IPCA figure, which surprised analysts once again printing a much lower than consensus +0.18%. Not only was food inflation much lower but also services IPCA slid from +0.48% in August to +0.20%. The lower IPCA is a strong element to refute the idea that the Brazilian economy was suffering from a demand-side shock.
Market conditions have significantly improved since the release of the quarterly inflation report. Moreover, worries about the pass-through from food to services have somewhat vanished as the likelihood of a generalized ‘contamination’ is very low. Looking ahead, we see a significant chance of a 25 bps on the coming meeting (Oct-17th) and, we would not discard another rate cut on the Deceber-5th meeting. The CB has already started FX interventions as the monetary authority has an open capital account and hence has chosen to bear nominal appreciation at the expense of lower inflation.
The question that we have stressed in previous analysis is the need for Brazil to cut rates more vigorously. In this situation, there would be a decrease in the risk premium and possibly a decrease in capital inflows. In turn, the monetary authority would not need to promote constant sterilization policies that end up increasing the fiscal service (or quasi fiscal) of the debt.
2. External Scenario: Overview
The latest World Economic Outlook argues that the world is experiencing longer periods of economic growth and shorter phases of recession. The question that the BCB has to take into account is: What are the impacts in Brazil of a US slowdown?
The answer to the above question has to take into account two scenarios:
1) No decoupling (ND)
2) Decoupling (D)
In the ND scenario the subprime crisis drives the US to a mild recession (soft landing). In this case, the decreasing in rates by the Fed will not prevent the slowdown in domestic consumption and production. In the ND situation, there is a slowdown in the key developed markets that are transmitted through trade and financial channels to emerging markets like Brazil. In this case, a slowdown in the developed world implies a decrease in US imports from China (and from Brazil). China, in turn, would decrease its imports from Brazil. Commodity prices would go down and hence, Brazilian exports would decrease. In turn, Brazilian current account would diminish leading to lower growth of output. On the financial side, lower interest rates in the US (and lower commodity prices) would induce a capital outflow from Brazil (flight to quality) leading to a depreciation of the BRL and an upward inflationary pressure.
In the decoupling (D) scenario, China and Europe would decouple from the US slowdown. In turn, commodity prices would not go down because Europe would absorb more exports from Asia in general and China, in particular. Brazilian exports would not be significantly affected and hence the impact in output would be minor. On the financial side, the weakening of the USD would continue, leading investors to leave the US in search for higher yields. In turn, capital inflows to Brazil would continue in the current levels and thus, the slowdown would be restricted to the US with few impacts in other countries.
3. Conclusion
In the traditional scenario (US slowdown without decoupling), the Brazilian Central Bank possibly would stop decreasing rates. The monetary authority would observe the amount of capital outflow, decrease in reserves and mostly the eventual inflationary impacts triggered by a depreciating currency. In the decoupling scenario, the Brazilian monetary authority would keep decreasing rates, mostly because the US slowdown would be isolated episode and the whole developed world would be registering positive growth rates.
In the absence of inflationary pressures in the domestic side and considering that the leading world economies have not displayed recessionary signs we believe that there is room for further easing. We invite you to give your opinion on this issue.
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