By Jamie McGeever
BRASILIA (Reuters) – Brazil’s central bank will likely be forced to put aside its misgivings and cut interest rates much further, testing the “lower bound” of rates as it battles against potentially the biggest economic crash on record and historically low inflation.
A debate over the lower bound, which has consumed various global central banks in recent years, is now raging in Latin America’s biggest economy as its rates are pushed to their lowest ever: At what amorphous point do rate cuts turn counterproductive and raise concern over inflation or financial stability?
The central bank’s rate-setting committee, known as Copom, reduced its benchmark Selic rate on Wednesday by 75 basis points to 2.25%, and said there may be room for further “residual” easing in the coming months.
Its accompanying statement and recent comments from policymakers show a reluctance to go much lower. They cite the potential damaging impact on the exchange rate, inflation expectations, investor confidence and overall financial stability.
But a growing number of analysts say the economic reality will force the hand of central bank chief Roberto Campos Neto, especially given that the institution is failing in its principal objective of meeting its inflation targets. For a country with a history of hyperinflation, this is a rare phenomenon.
(Graphic: Brazil inflation vs target – JP Morgan – https://fingfx.thomsonreuters.com/gfx/mkt/dgkvlwrzopb/INFLATIONJPM.png)
“They will have no choice. Their diagnosis of the crisis is mistaken, thus so is their remedy,” said Jose Francisco Goncalves, chief economist at Banco Fator in Sao Paulo, faulting the central bank for not grasping the severity of the current downturn.
“The central bank will have to do ‘whatever it takes’ to support the economy and bring inflation back up to target,” he said, predicting that the Selic will eventually be cut to 1.5%.
SELIC 1.00%?
A growing band of economists is getting on board with that view. Cassiana Fernandez at JP Morgan sees the Selic ending at 1.75%, and Gustavo Arruda at BNP Paribas and Dev Ashish at Societe Generale reckon it will go as low as 1.5%.
Carlos Kawall, director at Asa Bank and a former treasury secretary, believes the Selic will be cut to 1.00%. Were it not for the lower bound debate, it might even be cut to zero.
“We continue to see room for significant additional monetary easing,” Kawall and his colleagues wrote in a note on Wednesday.
Central to this thinking is inflation, or rather, the lack of it. Annual consumer price inflation in Brazil, where inflation nudged 7,000% only a generation ago, is currently 1.9%, the lowest in over 20 years.
(Graphic: Brazil inflation – annual rate – https://fingfx.thomsonreuters.com/gfx/mkt/nmovakzdzva/INFLATIONYY.png)
(Graphic: Brazil infllation – monthly rate – https://fingfx.thomsonreuters.com/gfx/mkt/yzdvxdwkevx/INFLATIONMM.png)
TAYLOR RULE
More importantly, inflation is significantly below the central bank’s 2020 goal of 4.0%. And by Copom’s own projections, which have fallen consistently in recent meetings, inflation will fail to get back to 4.0% this year or next year’s goal of 3.75%.
Using a mix of exchange rate and interest rate variables, Copom on Wednesday estimated that inflation will end this year at 2.0% or 1.9%, down from a projection of 2.4% or 2.3% at last month’s meeting. Similarly, the 2021 projections were lowered to 3.0% or 3.2%, from 3.2 or 3.4%.
With the economy on course to shrink more than 6% this year, according to market consensus, high unemployment and weak demand should continue to put downward pressure on inflation, despite a 25% slide in Brazil’s currency against the dollar this year.
In this context, the “Taylor Rule,” an economic model which predicts where interest rates should be to bring inflation to target, points to much a much lower Selic.
(Graphic: Brazil ‘Taylor Rule’ – BNP Paribas – https://fingfx.thomsonreuters.com/gfx/mkt/jbyprlzdqpe/TAYLORRULE.png)
But the resistance among policymakers is strong. Campos Neto has said the lower bound is difficult to pinpoint and depends on several variables, and there is no consensus in Copom on where that level is.
And unlike central banks in developed economies like the U.S. Federal Reserve or European Central Bank, there is a risk premium attached to Brazil that limits how aggressively Copom can act.
Part of the hesitancy may also be once the lower bound is reached, the next frontier in stimulating the economy and reviving inflation is extraordinary policy measures such as bond-buying, or quantitative easing.
That is a path the central bank is even more reluctant to go down.
(Reporting by Jamie McGeever; Editing by Christian Plumb and Leslie Adler)
