Brazil: Restarting the hikes
This post is a guest contribution by Gray Newman of Morgan Stanley.
When Brazil’s central bank meets this week to review monetary policy, there is little doubt now that the authorities will raise interest rates. After having begun a hiking cycle just nine months ago – and then stopping the cycle just months later – the authorities now appear to be on track to resume with a series of hikes. We believe the most likely outcome is that the authorities will hike the overnight reference rate by 50bp to 11.25% on Wednesday, January 19. And while we reiterate our call that rates will rise to 12.50% during the year, we are concerned that the path is far from clear.
Inflation’s Origin? The Growth Mismatch
Last year when the central bank decided to abort the hiking cycle in early September, many argued that the hiking cycle was over. We maintained then and maintain now that more rate hikes would be needed in 2011. Our concern was simple: at the core of Brazil’s inflation problem was a mismatch between robust demand and sluggish supply (the Growth Mismatch). With limited visibility of any significant fiscal tightening, we argued that Brazil’s central bank would have little choice but to hike interest rates during 2011.
Brazil’s Growth Mismatch, in turn, is the result of the positive wealth shock, thanks to multi-decade high terms of trade and with it a multi-decade strong exchange rate. While a positive wealth shock sounds like good news, it also poses challenges. Indeed, it is what we refer to as the ‘risk of abundance’. A strong currency (along with credit expansion, consumer confidence and strong job and wage growth) has boosted the purchasing power of Brazilian consumers and produced consumption indicators as robust as we have ever seen in Brazil. The flipside, however, of a strong currency is the threat to domestic producers faced with new import competition. The result: robust demand side-by-side with sluggish supply.
Indeed, the latest data from Brazil released in the first weeks of the New Year continue to highlight the presence of Brazil’s Growth Mismatch. Industrial production in November was off -0.1% from the previous month, the fifth monthly downturn in the past eight readings. Industrial output, after peaking in March, has been largely stagnant since then. In contrast, retail sales growth remains robust. This past week we learned that retail sales in real terms rose by 1.1% in November: that is an annualized pace of more than 13%. And preliminary data suggest that demand for consumer credit remained robust in December.
Preliminary data and anecdotal evidence from December – from measures of heavy vehicle traffic on toll roads to car production and packaging paper demand – suggest that December’s industrial output could show an upturn after November’s disappointing downturn. That is certainly possible, but we would warn that we have been hearing advocates argue that industrial production was about to turn up – always next month – ever since we first began to highlight the Growth Mismatch at mid-year. There are indeed signs of an improvement in December, but we doubt that one month’s report will fundamentally change the broader picture that Brazil is facing – that of a stagnant industrial plant – which we suspect is due in part to the strength of the Brazilian real to levels that we have not seen in decades.
With uninterrupted evidence of the Growth Mismatch, it is still somewhat puzzling that the authorities stopped the hiking cycle with the last move in interest rates in July. The authorities have since argued that concerns over a failed bank played an important role in the decision to abort the hiking cycle. But by later last year, it seemed clear that the banking concerns had been contained and the drivers of inflation – robust consumer demand, boosted by stimulative fiscal and credit policies – all remained in place.
Three Factors Behind the Delay
We suspect that three factors delayed the move to restart the rates hiking cycle. An examination of these factors also suggests the risks present in 2011.
First, it is difficult to avoid the conclusion that political considerations played some role in the timing of the move to restart the hiking cycle. The regularly scheduled Copom meeting in October fell precisely between a two-round presidential election process: it is understandable that the central bank might have felt that a move on the rates front between rounds of voting could have cast an unnecessary spotlight on the actions of the monetary authority. At the next meeting in December, the case again could have been made that the Growth Mismatch (strong consumer demand side-by-side with sluggish supply) was present. But again, the political timetable might have played a role in the delay in December: a hike just before a change in central bank leadership could have been read as a sign that the new team needed the help of the outgoing leadership to jump-start the hiking cycle.
Second, monetary policy actions are rarely taken in a vacuum: monetary policy takes into account other policy actors – and on that front there has been some uncertainty over future non-monetary policy actions. The decision to hike rates as well as the timing and the magnitude of the hikes is also a function of other policy measures, including fiscal and ‘macro-prudential’ policy. In December, on the eve of what many rates watchers thought was the restart of the hiking cycle, the authorities announced a series of “macro-prudential” measures – hikes in reserve requirements and higher capital ratios designed to slow credit expansion. That move led the central bank in its December minutes to argue that while the credit measures were not “perfect substitutes” for monetary policy they were powerful and that the central bank needed “additional time” to “better measure” the impact before deciding on the course of monetary policy.
Of course, the macro-prudential measures are not the only policy actions the central bank is monitoring. There has been significant talk from the new administration of an important commitment on the fiscal front that would not only ease pressure on the rates front, but could be the catalyst to allow Brazil to lower interest rates. That policy uncertainty likely played a role as well in the decision to delay until now the restarting of the hiking cycle.
Third, identifying Brazil’s inflation dynamic has been challenging. After a significant uptick in inflation in the first months of 2010 – consistent with our call that demand was growing well above potential – monthly inflation turned down sharply during June, July and August when it averaged near zero percent for three consecutive months. There was some confusion: demand continued to outstrip supply and yet headline inflation appeared contained. Then at the end of the year, the uptick was largely centered in food and in part exaggerated in the year-over-year reports, given an unfavorable base of comparison. Indeed, we expect to see some reversal in the year-over-year reports in the first months of the year. It’s worth noting that food, which accounts for just under one-quarter of the Brazilian consumer price index IPCA basket (23.1% at the end of 2010) accounted for nearly half of the 5.91% inflation result for the year. But it would be a mistake to blame this simply on food: service and non-tradable inflation has been consistently running near 7% for much of the year – well above the 4.5% overall target. In the end, we suspect that the magnitude of the upturn in inflation as well as the deterioration in inflation expectations played a role in bringing the central bank back to the hiking cycle.
Macro Is Back
Our concern, however, is that it is far from clear how this cycle will end. While we have a central forecast of a series of hikes bringing rates to 12.50%, we suspect that there is still significant uncertainty surrounding that path. Brazil has had limited experience in which a hiking cycle was the proximate cause of a slowdown in demand: as often as not either events from abroad or domestic political concerns were the culprit in turning the business cycle. Add to this the political cycle as well as the potential tension with other policy measures – a hiking cycle can easily put undesired pressure on the currency to strengthen further – and the path becomes murky. And there is still considerable support within the administration that enough will be accomplished on the fiscal front so as to allow a reduction in interest rates.
Some may read this week’s move to hike rates as a victory for the central bank in regaining the upper hand after Brazil’s inflation moved close to 6% and approached the upper end of the inflation targeting band. We would be wary about overplaying the significance of the move. Instead, we suspect that the Brazilian policy response will be tested by the powerful wealth shock hitting the economy – simultaneously boosting domestic demand even while limiting the growth in supply. It is far from certain what exactly the mix of policies will be in response or how successful they will be.
Source: Gray Newman of Morgan Stanley, January 19, 2011.
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