Even though domestic activity was slowing down since the beginning of the year, inflation continued to trend up as inertial price adjustments (especially in services) gained momentum and the labor market remained strong.
 
After moving up from 4.5% in August of 2010 to 7.3% in September, yearly inflation is expected to trend down from now on. The first step in this direction was the drop to 7.0% in October, the first in more than one year. The main support for this slowdown is statistical, due to high-base effects. Nonetheless, the slowdown of the domestic activity and the deceleration of global growth will add to this and reinforce the decline of yearly inflation.
 
The main issue, therefore, is not whether inflation will weaken or not, but rather at what speed. The first issue to take into account is that domestic prices are in general very sticky in Brazil. In the 2008-2009 crisis, for example, inflation declined from 6.4% in October of 2008 to 4.2% in December of 2009 (barely less than the 4.5% inflation target), even though the economy fell into a (short) recession and commodity prices plummeted.

In addition to that, neither commodity prices nor domestic activity should drop significantly. They will rather stay relatively strong, creating obstacles for inflation to converge to target in 2012. Finally, bear in mind that the 14% minimum wage adjustment to be enacted in 2012 should also provide some support to inflation.

A simple exercise, illustrated in the last graph, should make clear the difficulties for inflation to reach 4.5% anytime soon. If one assumes monthly inflation will from November on behave exactly as in the previous crisis, meaning it will drop to 0.36%m/m and 0.28%m/m in the last two months of the year and then average 0.35%m/m in 2012, inflation would then converge to 4.3% by the end of 2012 (instead of the base case scenario of 5.4%). There are, however, two main differences with the previous crisis. First, last time the country went through a recession and GDP fell 0.6% while this time the economy is expected to grow 3.6%. Second, in the 2008-2009 episode monetary policy was much tighter than now as at that time the CB increased the SELIC to 13.75% at the beginning of the turbulences (as inflation was still high). At this time, the CB will have cut the SELIC to 11.0% by the end of the year (in spite of inflation being high). On top of that, the 14% minimum wage adjustment next year is clearly another source of concern.
This does not mean that it is impossible for inflation to converge to 4.5% in 2012. It means that this would only happen if the crisis turns out to be as serious as in 2008-2009 which is clearly not the main scenario. The CB’s benevolent view of inflation is a move to justify extra cuts of the SELIC. More than moving to a system where the CB focus on both growth and inflation instead of only inflation, we see the implementation of an strategy (or a bet?) to take interest rates permanently down to levels closer to observed in other countries.

This is a risky strategy with potentially high costs in terms of credibility. Even if inflation ends up converging to 4.5% next year as the CB has been saying, there will be a credibility cost for the monetary authority as its monetary strategy has sounded more as a bet or a wish than a technical decision. This implies that inflation could remain high over a longer period, especially after global tensions ease.
 

Independently of these costs, expect the SELIC to be cut by 50bps in the next monetary policy meeting at the end of November and then to close the year at 11.0%. For the next year, the space for additional cuts will be limited by a less supportive fiscal policy (fiscal target to be met this year but not in 2012) and also by the fact that inflation should not converge to the 4.5% target as soon as the CB expects, but the monetary authority should find/create some room for continue cutting the SELIC. BBVA expects it to be at 10.0% by the end of 2012, but a one-digit rate should not be ruled out.

Source: BBVA Research

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