By Mary Stokes, Timetric.
Brazil’s policy rate – the SELIC – is at an all-time low of 8.5% following a cumulative 400 basis points (bps) in cuts since August 2011. The rate cut cycle is set to continue. We now expect the central bank (BCB) to reduce the rate further, to 8%, at the next meeting on 10-11 July. The BCB is clearly dovish, and additional monetary easing beyond July cannot be ruled out. However, we believe further rate cuts represent a risky policy gamble.
Although we acknowledged the possibility of further easing in our latest Monthly Forecast, Timetric had expected the BCB to leave the SELIC rate at 8.5% for the remainder of 2012. However, the dovish tone of the minutes from the May monetary policy meeting, released on 8 June, have prompted us to lower our interest rate forecast to 8%. According to the text, the monetary policy committee “considers that risks to the inflation trajectory remain limited at present.”
A range of factors have opened the door to further monetary easing. First, domestic economic activity is weak. In Q1 2012, GDP surprised negatively, rising by only 0.8% on an annual basis, marking the worst outturn in ten quarters. Second, policy makers appear intent on permanently reducing the policy rate closer to levels prevailing in other major emerging markets (Chart 1). Finally, the global backdrop has deteriorated, and the monetary policy committee emphasised the disinflationary external environment in its meeting minutes, stating the world economy was “facing a period of above average uncertainty, with elevated risk aversion and prospects of low growth.” China cut interest rates this month for the first time since 2008, while the eurozone crisis rages on unresolved.
Despite the factors mentioned above, we believe that hurrying through additional rate cuts is a risky strategy for the following reasons. First, the BCB has lowered the SELIC to an all-time low, and we believe it should now take a pause to evaluate the effect of its policy action. Other central banks in Latin America (such as Chile and Colombia) have adopted this prudent wait-and-see approach.
Second, the BCB has shown a willingness to tolerate above-target inflation, but we believe the recent weakening of the currency and the rise in inflation expectations in recent months are major concerns. Although annual inflation has followed a downward trend since late 2011, we expect a reversal in the coming months, which will make it harder for the BCB to justify further easing (Chart 2). With additional rate cuts, the BCB runs the risk of eroding its inflation-fighting credibility. It has worked hard to overcome its legacy of hyperinflation in the 1980s and 1990s, and it would be unfortunate if it started to backtrack.
Finally, the severe deterioration in the global environment makes further rate cuts a dangerous proposition. At the height of the global financial crisis, Brazil and many other emerging market experienced sharp reversals in capital inflows, which exacerbated their economic downturns. In the event of a similar external shock (such as a disorderly breakup of the eurozone), additional monetary easing could end up aggravating capital flight, further depressing economic activity. A rate cut in July is practically a done deal, and a SELIC rate below 8% remains a very real possibility. Nevertheless, we believe further easing is not worth the risk.
Source: Timetric (Mary Stokes)