Falling Inflation Supports Rate Cuts

Large economic slack and global disinflation have joined forces to pull Brazil’s inflation outlook below the official target center. In turn, falling inflation opens the door for further monetary policy easing. The market consensus is looking for a 100bp rate cut on April 29, but we believe that there is room for a 150bp rate cut.

Inflation Heads South

Inflation is set to fall below the central bank’s 4.5% target. Headline consumer price inflation (IPCA) slowed from a recent peak of 6.4%Y in October 2008 to 5.9% in December last year, and then to 5.6% in March 2009. Looking ahead, we expect IPCA inflation to drop to the 4.5% annual target by around mid-year, and then to fall further, towards the 3.0% mark by end-2009.

Inflation components will likely rotate: market-driven price inflation should fall, while administered price inflation should rise. Backward-looking, so-called administered (or monitored) price inflation has run below headline inflation over the last couple of years. But it has been trending up since early 2008 and seems likely to rise further. The central bank assumes that administered prices will rise from 3.5% in 2008 to 5.5% in 2009, while we and the market consensus expect 4.5% this year. One wild card here is regulated fuel prices – a cut in domestic gasoline and diesel prices could reduce IPCA inflation by a few tenths of a percentage point. For its part, market-driven price inflation has slowed from a recent peak of 8.0%Y in 3Q08 to 7.1% last December and 6.1% in March 2009 – we assume a further decline, all the way to about 2% by end-2009.

Looking ahead, inflationary pressures seem subdued. Wholesale price inflation has trended lower over the last several months. In particular, volatile agricultural wholesale price inflation had jumped higher around mid-2008 but has since come down all the way to zero.

Currency pass-through to inflation is proving remarkably muted, despite significant currency depreciation in late 2008, and unlike the 2002/03 experience. Why? We can see four possible explanations. First, as the inflation-targeting regime matures and the central bank gains credibility, the currency loses importance as an anchor for inflation expectations. Second, the real effective exchange rate seems to have moved towards its longer-term average in the recent episode, but away from the historical average back in 2002/03. Third, ongoing global disinflation helps. Fourth, a weakening domestic economy probably helps to reduce the pass-through coefficient.

Global disinflation helps. After a sharp run-up throughout 1H08, global inflation has turned decisively lower over the last several months. Looking ahead, the IMF foresees global CPI inflation slowing from a peak of 3.4% in 2008 to 1.8% in 2009, with zero inflation in advanced economies and 4.4% in emerging markets.

A weak domestic economy helps to curb inflation. Brazil’s output gap has widened dramatically. That is, the economic slump in late 2008 brought real GDP growth significantly below its potential. And while there are recent ‘green shoots’ of sequential recovery, we fear that a double-dip cannot be ruled out. The end result: resource utilization in the economy has declined sharply, as seen in a sudden plunge in industrial capacity utilization around the turn of the year. Under low operating rates and limited corporate pricing power, profit squeezes seem more likely than inflationary pressures.

Not surprisingly, market consensus of inflation expectations keep coming down. The consensus for IPCA inflation in 2009 continues to fall, from a peak of 5.4% late last year all the way down to around 4.2% in recent weeks – therefore already below the official 4.5% target center. Interestingly, the market consensus for 2010 inflation has also started to drift lower in recent weeks, after being firmly stuck at the 4.5% target mark for several months.

Rates to Fall Further

Falling inflation expectations make room for further rate cuts. Indeed, if history is any guide, it seems there is a significant correlation between market consensus expectations for IPCA inflation (12-months ahead) and policy interest rates, perhaps with a time lag on some occasions.

The central bank’s own inflation forecasts are coming down too. In its latest quarterly inflation report, as of late March, the central bank revised down its forecast for 2009 IPCA inflation to 4.0% from 4.7% before, under the reference scenario of unchanged policy rates and a stable exchange rate. Likewise, it cut its 2010 IPCA inflation forecast, also to 4.0%, from 4.2% before.

The market consensus expects COPOM to cut rates by 100bp, but we see room for a 150bp cut when the monetary policy committee announces its decision on the evening of April 29. We see three main reasons for a larger room to cut. First, the economy has opened a wide output gap, with plenty of slack in resource utilization. Second, inflation expectations are falling steadily, below the central bank’s 4.5% target. Third, in the ‘balance of risks’ facing the COPOM, the risk of deeper recession is a more dangerous threat than the risk of rising inflation, in our view.

Watch the accompanying policy statement and the subsequent COPOM minutes, out on May 7, aside from the (split?) voting score, for clues on next policy moves. If the COPOM indeed opts for a bold 150bp rate cut now, it could present its decision as ‘buying insurance’ against the tail risk of a deeper recession. In this case, the COPOM might highlight its role as a ‘risk manager’, and it could underscore the concept of ‘balance of risks’ around the base-case outlook.

The central bank currently seems to contemplate two main scenarios. In the first, the global turmoil would last for longer, extending into 2010, and its negative repercussions for Brazil’s economy would persist throughout the forecast horizon. In the second, if the global recovery comes sooner and faster than anticipated, then the recuperation in financial conditions and confidence, besides rising commodity prices, could imply rising inflation risks. At least until recently, the central bank has judged the first scenario as the most likely.

By contrast, a slowdown in the pace of cutting (say, to 100bp or less) might signal a change of perceptions at the central bank. In this case, the COPOM might prefer to highlight the lagged impact of the cumulative easing already implemented so far (100bp cut in January, and 150bp rate cut in March). In this ‘proceed-with-caution’ case, the COPOM might prefer to signal a slower rate-cutting pace going ahead, perhaps in order to minimize the odds of subsequently having to hike rates too soon.

Any rate cut from here would bring rates to uncharted territory, as the policy rate currently already stands at a historical low of 11.25%. In all, we expect rates to slide to unprecedented lows – our forecast assumes a 150bp rate cut now in April, and then another 150bp cut at the subsequent meeting in June. Rates would therefore decline to 8.25% by mid-2009, and remain there through year-end.

Rates are coming down. How long can they stay there? The debate here boils down to structural versus cyclical considerations. Analysts in the ‘multiple equilibrium’ camp would argue that once real rates fall, they may well stay there sustainably. By contrast, observers in the ‘emergency cuts’ camp would argue that ongoing aggressive rate cuts are an emergency response to fight recession, and that structurally lower real interest rates would likely require structural reforms. Who is right? We do not know. While both camps have good arguments, we sympathize more with the latter. In our view, policy rates might have to go up at some point in late 2010. That said, the local yield curve seems too steep right now, as it appears to price in rate hikes already by early next year.