By Mary Stokes.
Annual inflation has trended steadily downwards since peaking at 7.3% in September 2011. Given sluggish domestic economic activity and weak global growth, price pressures are not a concern, at least not in the near-term. Analysts now see inflation slowing to 4.9% in 2012, according to the latest central bank survey, compared with expectations of 5.4% at the start of the year. Nevertheless, we do not expect this decline to prove lasting.
What is surprising is that inflation is not lower. Global commodity prices fell by 7.2% annually in May, according to IMF data, while GDP growth registered its weakest annual reading in ten quarters in Q1 2012. Despite these disinflationary developments, annual inflation remains above the mid-point of the central bank’s target range of 2.5% to 6.5% (Chart 1).
Chart 1: Inflation and the SELIC rate have fallen since 2011
This should serve as a warning signal to policymakers who want a lasting reduction in the SELIC rate. Even though the SELIC currently stands at an all-time low of 8.5% with further cuts expected, Brazil’s policy rate remains higher than those in most other emerging markets. The danger is that when growth picks up, inflation will follow suit, making it challenging for the central bank to keep the SELIC rate at the current, low levels.
So why is inflation above target in the current disinflationary environment? The short answer is the labour market. Despite weak growth, the unemployment rate is close to a decade-low and wage pressure is visible in the divergence in inflation between tradables and non-tradables. The non-tradables sector consists largely of services, which cannot be readily exported or imported. In May, prices for non-tradables rose by 7.5% annually, compared with just 3.5% for tradables.
Part of the issue is cyclical. The unemployment rate tends to be a lagging indicator. Given weak economic activity, we expect a modest increase in unemployment in the coming months, which may help ease wage pressure.
However, part of the issue is structural, which has prevented a more significant slowdown in inflation. For example, Brazil suffers from a shortage of skilled labour – a structural issue related to the government’s historic under-investment in education. According to Manpower’s 2012 Talent Shortage Survey, Brazil ranked second, behind only Japan, with 71% of employers reporting difficulties filling jobs. This has contributed to inflationary wage increases (Chart 2).
Chart 2: Unemployment near decade-low, real wages on the rise
The government’s minimum wage policy is also a structural stumbling block to lower inflation. The policy, enshrined into law in February 2011 but de facto adopted in 2007, helps perpetuate inflation by ensuring minimum wage hikes consistently outpace rises in consumer prices when the economy is growing. One of the main problems is that the minimum wage is determined by a backward-looking formula based on real GDP growth two years prior.
If the government were to peg rises in the minimum wage to rises in labour productivity and consumer prices, rather than rises in overall GDP growth from two years prior and consumer prices, this would help limit inflationary pressures. Most importantly, it would bring the government closer to achieving its goal of a lasting reduction in interest rates.