Brazil going Turkey? Not quite

February 13, 2012

Could Brazil be on the cusp of  adopting a Turkish-style monetary policy,  J.P. Morgan analysts ask.

Many central banks have of late been forced to scale back interest rate cuts (here’s something I wrote on this topic last week) but one, Brazil’s Banco Central, remains resolutely dovish.

After four rate cuts it seems determined to take the official Selic rate into single-digit territory.  Aldo Mendes, a deputy governor at the bank, told investors in London last week that he was confident of meeting the 4.5 percent inflation target this year. Friday’s data showing annual inflation at an 11-month low of 6.22 percent should have given policymakers some more ammunition.

Yet it looks unlikely that inflation can fall this year to 4.5 percent  — on average analysts expect 5.3 percent. That’s better than last year’s 6.5 percent but government plans for a spending binge to boost growth are bad news for the central bank’s target. Inflation expectations are steadily trending higher — analysts surveyed by the central bank predicted 2014 inflation above 4.5 percent for the first time last November and now this is close to 5 percent, JPM analysts note. The risk for the central bank is it will lose credibility if it insists on keeping policy loose in the face of rising inflation expectations. There is no “free lunch”, JPM says:

Lower rates could mean credibility costs and in turn higher inflation….It seems the BCB is losing credibility as we see changes in the market’s inflation expectations for the medium term. Taking that and our strong activity forecast from the second quarter onwards we now believe it will take much longer for inflation to converge to the middle of its target range. Therefore we are raising our inflation forecast to 5.5 percent in 2013 from 5 percent previously.

Check out the following graphic from JPM on inflation expectations in Brazil:

JPM reckons the Banco Central will not abandon plans to cut rates (the market expects rates to fall to 9.25 percent this year from the current 10.5 percent). But nor will it abandon inflation-targeting altogether. Instead JPM analysts predict Brazil will resort to other tightening tools to cool the economy while keeping interest rates low. That will likely involve raising banks’ reserve requirements in order to tighten credit and money supply, JPM says.

The question is: will this be done at the same time as cutting the official interest rate? That’s the experiment Turkey pioneered back in December 2010 — it recognised the need to tighten policy but seeking to preserve growth, it unexpectedly cut rates and insisted on keeping them low even amid spiralling inflation and an overheating economy. The experiment is widely acknowledged to have failed. Brazil is likely to act more conservatively despite the keenness to cut rates, JPM says:

Is this a Turkish-style monetary policy? At first glance it certainly reminds us of it but up until now we do not expect to see these opposite movements happening simultaneously….we expect the central bank to resume tightening using macro-prudential instruments by the end of this year and only raising interest rates by the end of the first quarter 2013.

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