Brazil: The real inflation challenge

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This post is a guest contribution by Arthur Carvalho of Morgan Stanley.

For most of the year, inflation has been the biggest concern among investors, as many are worried that the upward trend would not be reversed. We have long argued that although Brazil has a serious inflation problem, it was exacerbated supply shocks last year and earlier this year that increased headline figures significantly. Although we have had only one inflation print that showed a decrease in yearly figures – October IPCA-15 declined from 7.3% to 7.1% – we believe that this is just the start of a trend. While this is certainly good news and should calm fears that inflation would run ever higher, this does not mean that Brazil’s structural inflation problem is over. We think that the path needed to achieve significantly lower inflation on a structural basis is viewed as too costly by the current administration, which has very clear growth goals. This does not mean that Brazil will lose control of inflation, but it does keep the risk of inflation risk in the debate and reminds us a bit of Brazil’s more distant past.

Favourable Base

We agree with Brazil’s central bank that the decline in the October IPCA-15 is likely to be the first sign of a new trend. After slowing from 7.3% to 7.1% in mid-October, we expect October’s final reading (to be published on November 11) to show further softening to 6.9%. Although this year was full of negative surprises on the inflation front, and the recent monetary policy reversal into an easing mode does not inspire great confidence for the medium term, the yearly inflation prints should fall more than 150bp over the next few months due to base effects. Two technical factors are likely to be responsible for most of the reduction in headline figures, neither of which are expected to contribute to a structural slowdown of inflation.

First, as we have highlighted, a significant part of the late 2010 run-up in headline inflation was due to a shock in the beef supply chain, which alone contributed 60bp in the last three months of 2010. It is important to remember that this shock had little to do with international commodities prices, as Brazilian cattle are actually grass-fed. Given that beef supply is determined by the breeding pattern from two years prior, we can already forecast that a similar supply shock is very unlikely this year. Combined with some other factors, this should reduce headline inflation from the current 7.3% to 6.4% by December.

Second, in 2011 many administered prices were adjusted in 1Q, whereas these adjustments are typically spread out throughout the year. Next year is set to have a more balanced calendar that should help to lower inflation readings during 1Q, but most importantly, some adjustments will simply not happen in 2012. Given the municipal elections that are scheduled for 2012, we do not expect to see major changes in public transportation tariffs.

There are benefits from lower headline inflation in a country as heavily indexed as Brazil. Most contracts and wage negotiations are indexed to inflation from the previous 12 months, so a slowdown in headline inflation should reduce pressures to a certain extent. Although this signals that inflation is unlikely to spiral out of control, the lowest point in our forecast path is 5.5% in early 2012; this hardly serves as a signpost for a downward trend towards the centre of the central bank’s target of 4.5%.

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Brazil: Preparing to end the hiking cycle

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This post is a guest contribution by Arthur Carvalho of Morgan Stanley.

When Brazil’s central bank meets this week, there is little doubt that the authorities will hike interest rates once again. We expect a 25bp hike to bring the Selic rate to 12.5% – a view held unanimously by central bank watchers. But in contrast with most Brazil watchers, we believe that this week’s move could be the central bank’s last move for the year. We interpret recent comments by the central bank as suggesting that it will end the rate-hiking cycle by August and possibly as early as this week. And given the growing uncertainty in the global environment, it would be easy to imagine a decision at the end of August indicating that it is time to hold off on additional rate hikes even if such a decision is not clearly telegraphed at the July meeting.

Our forecast of the central bank’s likely path – one more rate hike in July to 12.5% and then on hold through next year – is not set in stone. We have held for nearly a year now that the hiking cycle would end at 12.5% and do not see enough reason to adjust our forecast. If we had held, as many now do, a hiking cycle ending at 12.75% we would probably not adjust our forecast either: there is simply not enough evidence to date to define with greater certainty if the central bank’s overnight interest rate target is set to reach 12.5% or 12.75%. But what does seem clear is that the central bank is approaching the end of the hiking cycle: that can be seen in the central bank’s diagnosis of inflation, its assessment of its action’s success and its understanding of the usual policy lags.

The View from the Central Bank

Look at the central bank’s diagnosis of inflation: inflation is largely a supply shock that erupted in the last months of 2010 in international commodity markets, combined with supply disruptions in a few localized domestic markets (most prominently beef) and compounded by weather-related shocks at the beginning of 2011. Did robust demand play a role in adding to inflationary pressures? Most certainly, and the central bank clearly recognizes that. But at the core, the origin of the uptick in inflation at the beginning of the year was a string of supply problems.

Now look at the central bank’s assessment of the success of its actions: inflation has plummeted after averaging 0.73%M during the first five months of the year. Indeed, the central bank’s models are forecasting monthly inflation at half that pace in the last seven months of the year. Certainly, the drop-off at mid-year is in part due to seasonal factors and there will likely be a gradual uptick towards the end of the year as seasonality works in the other direction. But inflation is on a path that the central bank believes is consistent with a return towards the 4.5% target. Of course, the return to a 4.5% path does not mean that inflation is set to reach 4.5% this year – the central bank’s own modeling puts inflation at 5.8% for end-2011. And the central bank seems to have contemplated that the August inflation reading, if measured on a year-on-year basis, is likely to show a peaking of the annual readings near 7% (above the 6.5% upper limit of its inflation band).

Finally, look at the central bank’s understanding of the usual policy lags: it is not likely to be until September or 4Q11 that the ‘full force’ of its actions are felt. While it is possible that the central bank keeps hiking throughout the remainder of the year, we believe the much more likely outcome is that the central bank decides to stop and argue that it is time to wait and assess the full impact of its actions. Monetary and macroprudential policies work with a lag, and the central bank believes that the six to nine-month lag remains in place.

Service Pressures

We remain concerned about Brazil’s inflation picture. On the one hand, we agree with the central bank’s emphasis on the role that supply disruptions played in the inflation scare at the end of last year and the beginning of 2011. We argued then that inflation was being misdiagnosed: Brazil had an inflation problem, just not the one that most analysts were focusing on. We argued that the uptick was concentrated in a handful of food items and that the risk of inflation spiraling ever higher was being overplayed by many. But our concern then is our same concern now: the rapid growth in domestic demand has pressured services or non-tradeable prices during the past two years. With unemployment running at record lows, an overheated labor market is producing pressure in wage inflation and service prices. Is inflation likely to spiral ever higher? We don’t think so. Is it consistent with a return to 4.5% inflation? We doubt it.

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Brazil: Making sense of macroprudential measures

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This post is a guest contribution by Arthur Carvalho of Morgan Stanley.

The following is a discussion between our Latin American banks analyst and two members of the Latin American economics team.

Jorge Kuri: Like many market participants, I am somewhat confused about the implementation of monetary policy in Brazil. The central bank has elevated macroprudential measures as important contributors to bringing back inflation to target. Yet, most of the macroprudential measures implemented so far are aimed at slowing bank lending and, regardless if they’ll prove successful in doing so, I still don’t understand how this can make a meaningful difference in reducing inflation. I simply can’t see how car loans, for example, are the culprit here. Isn’t the inflation problem a combination of expansionary fiscal policy, high commodity prices and growing monetary base?

Gray Newman: Jorge, that’s a tall order. Let me take it in parts. First of all, you are right that the inflation Brazil is experiencing today isn’t simply about auto loans. Indeed, a strong currency is playing a big role. In real, that is to say, in inflation-adjusted, trade-weighted terms, the Brazilian currency is at its strongest level in over two decades. And this means that Brazilian consumers are enjoying a level of purchasing power that many haven’t seen in their lifetimes. I don’t have to tell you how many new iPad 2s I saw last month in the waiting lounge in New York before heading to Sao Paulo the day after the iPad’s launch to make my point.

And you’re also right, in our view, to argue that the fiscal and quasi-fiscal authorities are also co-responsible for the strong demand story in Brazil. In my view, faced with strong demand, the fiscal authorities should be withdrawing stimulus by running an overall budget surplus; instead, Brazil continues to run an overall budget deficit, meaning the authorities keep adding stimulus.

But I am not sure where that takes us when looking at the central bank. After all, the central bank can’t set fiscal policy or quasi-fiscal policy for that matter – both are starting points for the central bank. Look at Brazil’s situation: you can also argue that if emerging economies weren’t bidding up the price of commodities, then Brazil’s currency might not be at a multi-decade high, boosting consumer purchasing power. But there is not much Brazil’s central bank can do about commodity prices or for that matter the accommodative monetary policy from the US which is also playing a role in ‘exporting’ easy money and consumption to Brazil.

Jorge Kuri: Okay, Gray. But why go after car loans? What’s wrong with the monetary policy instrument, i.e., Selic rates, that Brazil has used for years?

Gray Newman: I hear from a lot of investors that yearn for the days when Brazil hiked interest rates aggressively. But look, the world is different. It’s not the same hiking interest rates in 2004 or 2005 when your currency is near multi-decade lows as when you are in 2011 and your currency is at a multi-decade high in large part due to global demand for your exports and an extremely accommodative monetary stance in most of the developed world. If you simply hike interest rates today, you run the risk of seeing your currency strengthen even further, and that can drive a further wedge in the economy by boosting consumer purchasing power while damaging your domestic productive sectors – what we call the Growth Mismatch (see “Brazil: Growth Mismatch Revisited”, This Week in Latin America, March 14, 2011).

And let’s be clear here: I don’t think that macroprudential measures should be seen primarily as an alternative to interest rates. I think the central bank is genuinely concerned about the rapid growth in consumer credit in Brazil and is acting prudentially to reduce the risk of credit bubbles forming before they take hold. But the authorities also recognize that macroprudential measures do have some impact on inflation and hence must be taken into account when using more traditional tools of monetary policy like interest rates. And it certainly doesn’t go unnoticed that macroprudential measures don’t tend to drive the currency stronger the way that interest rate hikes can.

On car loans and inflation, look at it this way: I don’t care where the credit is being given – if you boost credit you free up disposable income to consume more elsewhere. It should come as little surprise that the area of greatest pricing pressure is in services. If you boost demand, goods prices rise less because you can largely import if there is a local shortage. It is much harder to import a service: you may decide to come to New York for a show or go to a hotel in Miami, but for everyday services in Brazil – eating out in a restaurant, hiring a babysitter – strong demand is likely to push prices higher. Except for a beef and produce temporary uptick at the turn of the year, most of Brazil’s inflation problem has shown up in services.

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Brazil: Fiscal hope?

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This post is a guest contribution by Gray Newman of Morgan Stanley.

In Brazil, as is the case in most emerging economies, all eyes are on the recent uptick in inflation and how policy-makers – particularly the central bank – will respond. While Brazil has an inflation challenge – the consequence of robust demand and sluggish production (the Growth Mismatch), we suspect that the specter of inflation has been exaggerated a bit.  Moreover, while most of the focus remains on the policy response from the central bank, Brazil’s policy mix for too long has placed too great of a burden on monetary policy even as fiscal and quasi-fiscal policies have remained accommodative.

Now comes word that Brazil may address its overreliance on monetary policy with a significant fiscal adjustment. Indeed, the authorities could release as early as this week details of a fiscal adjustment that could involve a significant reining in of the fiscal accounts.  Even as we remain hopeful and would welcome a fiscal adjustment, we remain cautious.

Grounds for Caution

Our caution on both the magnitude and the scope of any fiscal adjustment in Brazil stems from three factors.

First, Brazil has a long track record of overreliance on monetary policy, with insufficient fiscal efforts. During the past decade, Brazil’s fiscal burden has continued to grow no matter how measured – in local currency terms, in US dollar terms or, most worrisome, as a percentage of GDP.  Primary spending of the central government as a percentage of GDP has continued to climb during the past decade and reached nearly 20% of GDP by the end of last year, while the composition of spending remains heavily skewed toward pensioners and current expenditures.  Investment spending remains limited, reaching only 1.2% of GDP in 2010.  Indeed, the tax burden – the broadest measure of fiscal spending which incorporates both federal and subnational spending – has continued to grow as a percentage of GDP reaching 33.4% in 2009.  In years of strong growth as well as in years of weak growth, election years and non-election years, government spending has continued to grow.  The authorities may now reverse that trend, but it is worth noting that the track record during the past decade has been one of ever increasing public spending.

Second, not only has Brazil’s track record shown the ever-increasing weight of state spending, but in recent years the authorities have increasingly turned to special accounting conventions that have served to overstate final fiscal balances. In 2010 alone we estimate that Brazil’s primary surplus would have been much smaller – closer to 1.8% of GDP, rather than the reported 2.8% of GDP – relying on non-recurring revenues. The authorities have been able to provide funding to the national development bank, BNDES, off-balance sheet and without having an impact on the net debt of the public sector (new borrowing by the federal government to fund BNDES is offset by an asset, BNDES’s promise to pay), but BNDES has in turn helped ease the expenses related to capitalizing the state oil company, effectively freeing up public spending for the federal government.

Indeed, although Brazil’s overall fiscal balance appeared to have improved in 2010 – the officially reported budget deficit was only 2.6% for the year, we argue that the underlying or cyclically adjusted deficit has worsened in the past two years.  If we take the average growth rate for GDP and Brazil’s terms of trade during the five-year period of 2000-04 as a proxy for a ‘structural’ revenue stream, we find that the ‘structural’ or cyclically adjusted balance deteriorated sharply in 2010.

Third, Brazil’s fiscal accounts have very limited flexibility making any significant fiscal adjustment extremely difficult. In the 2011 budget, nearly three-quarters of the R$773 billion budget is non-discretionary.  And most of the remaining R$220 billion in ‘discretionary’ spending includes almost the entire healthcare budget, half of the education budget, the PAC investment program and the highly visible Minha Casa Minha Vida housing program.  All of these items are quite politically sensitive, making it difficult for the government to successfully implement meaningful cuts.

There has been a discussion that the spending adjustment could be as large as R$50-60 billion.  We find it difficult to imagine that a fiscal adjustment could be implemented of that magnitude: that is nearly one-quarter of the entire discretionary budget.  And it is worth noting that even if just over R$50 billion of cuts could be made (the amount needed to reach the 3.1% primary surplus without special accounting treatment), total spending would still rise in real, inflation-adjusted terms.  The alternatives to a spending cut of this magnitude would be either some offsetting measures designed to boost revenues (a worrisome development given Brazil’s already high tax take) or a structural change that opens up some of the ‘non-discretionary’ parts of the budget.  Indeed, we would argue that a successful fiscal adjustment should contain three elements.

Grounds for Optimism

What will we be looking for to judge the success of any fiscal efforts? We would highlight three elements that would give us reason for optimism.

First, given the current dilemma that Brazil finds itself in – robust demand accompanying stagnant production (the Growth Mismatch), the authorities should aim for no additional fiscal stimulus. Indeed, given the pace at which demand is outstripping supply, Brazil’s fiscal efforts should be geared to reining in demand pressures by running an overall public sector surplus.  Of course, such a radical departure from the 2011 budget that has already been approved by congress is unlikely to be announced during February even though Brazil’s executive branch does have the flexibility to set lower spending ceilings through ministerial decrees.  But we would welcome any first signs of policy movement that targets Brazil’s overall fiscal balance (currently a deficit) rather than the primary balance.

Second, any fiscal effort should pave the way for a reform of Brazil’s growing non-discretionary spending formulas. The limited maneuvering room provided with discretionary spending should prompt the authorities to revisit social security reform.  At the present, pension benefits rise not only with inflation (keeping pension benefits from being eroded by inflation is a laudable goal), but also with the increase in the minimum wage (which has consistently run above inflation).  And private-sector employees still have no minimum age provisions as long as the provisions regarding the length of contributions are met.  The result: Brazil’s total pension costs as a percentage of GDP rival those of many northern European countries even though Brazil’s demographics reflect a much younger population.

Third, Brazil should move towards adopting a fiscal rule that provides for an overall structural fiscal balance or surplus. Given the important revenues expected to be associated with Brazil’s new oil and gas fields, it can be argued that future generations would be best served with a fiscal policy that aims for a structural surplus or at the very least a cyclically adjusted fiscal balance with excesses funding new investment projects.

Of course none of these measures – a shift in focus from targeting a primary balance to an overall budget balance, a series of reforms in the pension sector, a structural or cyclically adjusted balance – are likely to be fully implemented in 2011.  But progress on each of these three fronts would help Brazil wean itself off of its overreliance on monetary policy and pave the way for lower real interest rates.

It is important not to confuse the longer-term structure challenges for Brazil  -included the need to reduce real interest rates – with the near-term challenge that Brazil is facing with a business cycle where demand is outstripping supply.  At times we are concerned that the new administration may be overly optimistic regarding what can be accomplished on the fiscal front in the near term and what the implications would be for interest rates in 2011.  While a comprehensive fiscal reform can lay the groundwork for a reduction in interest rates, we expect 2011 to be a year of rising, not falling interest rates.  (The precise mix between interest rate and non-interest rate measures by the central bank is still not known, although we remain in the camp that the authorities will rely more heavily on non-interest rate measures than most market participants expect.  After all, after arguing for the past eight months that the Growth Mismatch – the growing divergence between robust demand and weak supply – was in large part the consequence of the multi-decade strong currency, December’s surprisingly weak industrial production report has finally attracted attention to our concern and that of the authorities).

Bottom Line

The advent of a new administration provides a promising opportunity to rethink the imbalance between Brazil’s fiscal and monetary policies. We welcome and encourage the renewed interest on the part of the new economics team to revisit Brazil’s fiscal accounts and agree with the assessment that a fiscal adjustment is a precursor to lower interest rates.

But we would argue that the fiscal adjustment needs to be structural in nature. The current earmarks and weight of non-discretionary spending virtually rule out the possibility that Brazil can implement a large enough fiscal effort in 2011 that would allow fiscal policy to act counter-cyclically.  While fiscal measures can reduce – but not eliminate – the fiscal impulse in 2011, a set of structural fiscal reforms can put Brazil on a healthier path, allowing it to simultaneously reduce the burden on the central bank and on interest rate policy while freeing up much-needed public resources to fund the important infrastructure needs of Brazil.

Source: Gray Newman, Morgan Stanley, February 9, 2011.

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Brazil: Restarting the hikes

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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.

Bottom Line

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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Brazil: Inflation showdown

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This post is a guest contribution by Gray Newman of Morgan Stanley.

In July, Brazil’s central bank faced significant criticism when it slowed the pace of its rate-hiking cycle – a cycle that had just begun in April – and prepared to stop hiking all together at its next meeting. The abrupt end to the hiking cycle was difficult to understand.  After all, the factors triggering the start of the rate-hiking cycle in April – robust domestic demand, fiscal stimulus ahead of the October elections, and rising inflation expectations – all remained in place in July.

We were puzzled as well. While we noted that domestic production had started to slump, domestic demand (which is a much more important driver of inflation) remained ‘red hot’.  Some argued that political forces were beginning to set the monetary policy agenda.  We argued that however difficult it would be to handicap near-term policy decisions – we ended up removing any hikes from the remainder of 2010 – we expected that the central bank would have little choice but to resume hikes in 2011 (see “Brazil: Slowdown – Comfort or Caution?”, This Week in Latin America, July 26, 2010).  Our call that rates would need to rise to 12.5% in 2011 was widely questioned at the time.

Now, just a month to go before the new administration takes office – and a new central bank governor, Alexandre Tombini takes over as new central bank head – the mystery of July appears to be resolved, at least in part. The abrupt end in the hiking cycle came as the central bank uncovered evidence of possible fraud at the country’s 21st largest lender and began to investigate to see if others were also involved.  The central bank admits that there were “absolutely legitimate” questions regarding its abrupt end in the hiking cycle, but argues that it could not divulge news of the troubled bank pending its investigation.  The implication of course is that with the resolution of the central bank’s investigation into the troubled lender (no other lenders have been implicated), the central bank can resume its hiking cycle.

Indeed, Brazil’s interest rate markets, which only a few months ago had been sceptical of rate hikes in 2011, are now beginning to price in rate hikes as early as the next meeting that concludes on December 8. And inflation readings – last week’s reading of the leading consumer price index, the IPCA-15 (November) posted its second-largest gain (0.86%) for the year – have raised considerable concern that Brazil is facing a major inflation problem.

While we reiterate our forecast that the central bank is likely to restart its rate-hiking cycle in 2011, we would warn against exaggerating the inflation challenge facing Brazil as well as the policy response. Four thoughts are in order.

First, a significant portion of the uptick in inflation as measured on an annual basis may be short-lived – year-over-year inflation is set to rise during 4Q and fall in 1Q11. Indeed, if we set inflation for each month beginning in 4Q with the average (seasonally adjusted) pace seen in 1H10, you would see year-over-year inflation rise by 70bp trough to peak from August to December 2010 and then drop by 70bp through April 2011.  The ‘uptick’ as measured by the annual inflation reading in 4Q would no more tell you about inflation dynamics in Brazil than would the sudden ‘downturn’ in the first months of 2011.

Of course, inflation in October and November are rising above the seasonally adjusted average of the first half of the year.  Our exercise is not designed to argue that inflation is not a concern, but only that the annual numbers released for October and to be released for November and December may exaggerate the worsening just as next year’s readings for the first four months of the year may exaggerate an improvement.

Second, most of the uptick in the annual readings has been concentrated in food: precisely where you should not be focused. While we have seen some broadening in the number of goods facing a larger price increase, the biggest change in recent months in the overall consumer price index (IPCA) has come on the food front.  Food IPCA has risen from a 4.1% annual reading in August to just under 7.5% in October.  While food prices have responded to global pressures, the uptick has been exaggerated again, given the base of comparison used for the annual readings.  Unless you expect to see another major move up in food commodity prices (not the base case for our commodities team, which believes that most prices have peaked), Brazil’s food inflation should show signs of easing in the coming months.

Third, the much bigger concern that we have been highlighting since mid-year is that domestic demand continues to grow at a much faster pace than domestic production (the ‘growth mismatch’). A prolonged period in which demand exceeds supply is likely to lead to higher inflation (as demand outstrips supply), a greater current account deficit (as a portion of demand is met with imported goods and services) or both.  Brazil’s growth mismatch can clearly be seen in both the growing current account needs as well as in worrisome services or non-tradable inflation (see “Brazil: Financing Mismatch”, This Week in Latin America, October 18, 2010).  The real problem facing the next administration’s policy-makers is not that food prices have temporarily risen – in part the effect of base periods of comparison and largely due to external factors outside the purview of central bank policy – but that services inflation has been running above 7% for much of 2010 and well above the overall 4.5% inflation target.  (Indeed it is the strength of the Brazilian real which has helped keep tradable inflation down.  Recall that Brazil, unlike many other emerging economies, is a major exporter of foodstuffs and rising dollar prices have helped to strengthen the Brazilian real, thus tempering the impact on local prices – that is, of course, when the authorities are not limiting the strength of the currency.)

Finally, while we expect the central bank to restart the hiking cycle that was cut short after the July decision, we still have questions regarding the reaction function of the new leadership which takes control in January. We have little doubt that if the current team remained in place, the central bank would resume interest rate hikes – as early as this month or, if not, in January.  But we believe that there is a difference in view among some of the key policy-makers in the next administration, which are intent on lowering Brazil’s real (and nominal) interest rates, with the more immediate task at hand for the central bank.  This can be averted if the central bank makes clear that its actions in early 2011 are in response to the business cycle and does not openly contradict the longer-term, structural view in favour of lower interest rates.

The key for Brazil to be able to reduce interest rates on a structural basis is likely to lie not with monetary, but with fiscal policy. Brazil’s overall fiscal stimulus in late 2010 was little changed from where it stood in mid-2009, despite the rapid rebound in demand.  The fiscal authorities have recently suggested that a significant fiscal adjustment will take place at the beginning of the next administration.  That indeed would be positive and could pave the way for a structural shift away from the current mix in Brazil, which has been dominated by loose fiscal and tight monetary policy.  But again, we await more details from the finance authorities.  In contrast, talk from some policy-makers of a new core inflation measure that would show less inflationary pressure is more worrisome. We think that Brazil’s current mix of monetary and fiscal problems demands a structural rethinking of fiscal policy, not simply a new inflation measure to add to the myriad of inflation indices already present in Brazil.

Bottom Line

Once again all eyes appear to be on Brazil’s central bank as Brazil-watchers await for clues as to when the new leadership will respond with a rate hike. We suspect that the excessive focus on the central bank and its policy response is misguided.  Brazil has a chance to rethink the balance between tight monetary and loose fiscal policy – that is the much bigger macro challenge facing policy-makers, in our view.  Absent significant progress on that front, the next central bank will likely find that it has limited degrees of freedom.

Source: Gray Newman, Morgan Stanley, December 1, 2010.

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