News & Analysis

At its March meeting, the BCB’s Monetary Policy Committee (Copom) unanimously decided to cut the Selic rate by 50 basis points for the sixth consecutive time to 10.75%.

This decision was consistent with the Bank’s forward guidance, which in its previous form suggested it’s easing cycle would be maintained at a pace of 50 basis points “in the coming meetings”, due to weak indicators of economic activity at the end of 2023, continued progress in inflation indicators, and the high level of the Selic rate. However, as we anticipated, risks heading into this meeting were that the BCB tightened its forward guidance in a more hawkish direction. In particular, not only did we find an interesting shift in the explicit guidance from anticipating cuts of the same magnitude, in the plural, to anticipating “a reduction of the same magnitude at the next meeting” if the Bank’s expected scenario is confirmed, but the tone throughout the statement was consistently altered in a hawkish direction. In February, Copom noted that headline and core inflation remained on track to converge to target, but with only one inflation report since, mention of inflation’s proximity to the inflation target was removed even as Copom note that headline inflation remains on a path of disinflation. Moreover, the BCB emphasised that several measures of underlying inflation are “above the inflation target in recent releases”, from “closer to the inflation target” back in February.

Taken together, while the BCB has maintained the pace of its easing cycle in Q1 2024, the risks of a tight labour market, persistent services inflation, upside fiscal risks and the narrow scope for the Selic rate to be cut before it hits the ex-ante neutral rate have led the BCB to update its “calls for caution” to explicitly guide markets towards a slower pace of easing from the May meeting onwards.

As noted, the risks to the disinflationary profile in Brazil are not disposable. On the one hand, the January labour market report continued to point to solid employment conditions in the Brazilian labour market, with unemployment falling further and wage growth accelerating from 3.1% to 3.8% at the beginning of the year. Additionally, in February, inflation data again showed only a marginal deceleration in the headline measure, which in our view casts doubt on the hypothesis that the mini-inflationary peak has passed. While some of the more inflationary categories may not pose an excessively high risk of worsening, of particular concern to the Bank is the still uncomfortably high level of core inflation, in particular core services, especially considering the surprising rebound in economic activity indicators at the beginning of the year that may become visible in forthcoming releases. However, this improvement in growth indicators does not seem to be enough for Lula da Silva’s cabinet which, in response to the recent worsening of their approval rating, seems ready to launch a more expansionary fiscal platform next week. While no concrete measures are yet known, the recent news about Petrobras and Vale SA, along with headlines about the government’s plans to temporarily freeze between 5 and 15 billion reais to avoid exceeding the spending limit under the new fiscal framework in this year’s first budget review, is a statement of intent. In our view, the budget announcement will be a key factor to be taken into account, paying particular attention to the nature of spending, productive or unproductive, and the areas to which it will be allocated to determine the inflationary capacity of spending at different time horizons and the most likely reaction of the monetary authority.

The BCB also finds itself with less scope to ease policy without it turning neutral, a stance that would be inconsistent with the aforementioned upside risks to inflation.

Based on the BCB’s estimate of the ex-ante neutral real interest rate of 5% and the median 12-month inflation forecast from the latest Focus survey, we have concluded that the nominal neutral interest rate currently stands at around 8.45%. Given that the current level of the Selic rate stands at 10.75%, this suggests that the BCB has only 230 basis points of room to cut its benchmark interest rate while maintaining a tight monetary policy to protect against upside inflation risks. The BCB’s room for manoeuvre to cut rates is therefore considerably less than suggested by the current spread between the Selic rate and the current inflation rate, also known as the ex-post real interest rate, which is considered a much less informative measure of the monetary policy stance compared to the ex-ante rate, as suggested by the BCB in a 2019 publication.

In any case, not all the details underwent a more hawkish twist at the March meeting. Notably, the BCB kept its baseline scenario unchanged. This sees inflation forecasted at 3.5% and 3.2% for 2024 and 2025 respectively. In our view, this suggests that, despite the slowdown in the pace of cuts, the BCB’s expected terminal rate is likely to remain stable with respect to previous estimates. Thus, the hawkish shift in their forward guidance likely reflects a preference to converge to this end point at a slower pace.

Overall, the March meeting has largely met our expectations and the consensus amongst economists. In the short-term, we believe the BCB’s more hawkish guidance will be generally positive for the BRL as it benefits from relatively higher yields in an environment of higher US rates and accelerated easing in peer economies like Colombia and Chile. That said, the extent to which this will be positive largely depends on fiscal developments. With the Lula administration looking to boost growth, there is a credible risk that a more hawkish central bank sparks another public feud with government officials.

As 2022 showed, this is viewed negatively amongst FX markets despite Brazil’s high level of carry. This risk is especially pronounced if the government’s spending plans breach its borrowing limits as it would not only risk the BCB abandoning its easing cycle and almost certainly ensuring friction with the government, but would also risk undermining investor sentiment on the basis of Brazil’s debt sustainability.

 

Author: 

María Marcos, FX Market Analyst

 

 

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