Don’t stop fighting inflation, banks tell Brazil policymakers

May 14, 2014

Brazil's Central Bank President Tombini reacts during a ceremony to announce Measures of Consumer Protection at the Planalto Palace in Brasilia

A small piece of good news on Brazil’s inflation rate last week probably gave the central bank its best pretext yet to finally stop raising interest rates after more than one year of non-stop increases. But economists still think it’s too early to proclaim “mission accomplished”.

Keeping interest rates at the current 11 percent will do little to reduce inflation in the months ahead, economists at Itau Unibanco, Santander and Bank of America Merrill Lynch said, despite a smaller-than-expected increase in consumer prices last month.

Their pessimistic outlook contrasts with the central bank’s, which has signaled it is willing to stop raising rates soon by saying that the 375-point increase since April last year was “sizable” and is yet to have a meaningful effect.

Behind the divergence are their opposing views on Brazil’s fiscal policy. They differ on how President Dilma Rousseff should be treating federal money on the run-up for a re-election campaign later this year.

The central bank says Brazil’s fiscal policy is moving towards neutrality. That is, it is boosting inflation at a slower pace than before, and will soon stop being an obstacle to monetary policy.

But Santander’s Brazil chief economist Mauricio Molan says there are plenty of reasons to be worried. Using three methodologies to calculate the impact of fiscal policy on the economy (IMF, OECD and the so-called Dutch measure), he concluded that a combination of stagnant tax revenues and growing public spending has actually increased the fiscal impulse to about 1 percent of GDP recently.

“There is no fiscal adjustment under way. Fiscal policy will have to be tightened further in 2015, which will likely slow GDP growth even further,” Molan said, forecasting inflation will be at 6.5 percent at end-2015, far from the government’s 4.5 percent target midpoint.

While he did not say that explicitly, it looks like increasing federal investment in roads by R$8 billion and postponing tax hikes on beverages to avoid beer price increases during the World Cup, two decisions announced this week, might not have been Brazil’s best choice.

Inflation is currently running at 6.3 percent. This graphic summarizes the extent of the problem:


Bank of America Merrill Lynch also reiterated their inflation concerns. Here is what David Beker and Ana Madeira said in a research note as they raised their 2014 and 2015 inflation forecasts to more than 6 percent:

“When inflationary pressures started to pick up and monetary policy started hiking rates last April, the expectation was for the fiscal policy to coordinate with the monetary policy and to ‘push’ toward the same end result. That did not happen. The central bank continued hiking rates and the government continued increasing expenditures, preventing the economy from cooling down, and with it, inflation.”

Therefore, stopping the current series of interest rate hikes at the May 27-28 meeting will probably lead just to a temporary pause, something Itau Unibanco’s Ilan Goldfajn agrees on:

“High inflation this year and next will likely demand an additional effort, so we forecast the Selic rate to reach 12.5 percent by end-2015.”

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