Brazil’s central bank confirmed today what most market observers have been predicting for months: interest rates are set to drop below 10% in the coming months.
In the minutes from its monetary policy meeting on January 18, when it cut rates by 50 basis points, the Central Bank Monetary Policy Committee (Copom) ascribed a “high probability” that Brazil’s benchmark rate, the Selic, would fall to single digits, citing both domestic and global concerns:
Copom stated (translation courtesy of MNI):
| Considering that the Brazilian economy's deceleration in the second half of last year was greater than anticipated and that recent events indicate a delay in a definitive solution for the European financial crisis, at this moment, Copom attributes a high probability to a solidifying scenario that contemplates the Selic rate moving to levels of a single digit. |
Copom also suggested that structural changes in the economy meant that Brazil’s “neutral” interest rate had become lower, and that interest rates should therefore fall into line with the new “neutral” rate.
Analysts see this is a clear sign both that Brazilian policymakers are prioritizing growth over efforts to combat inflation and that the central bank sees the current global crisis as an opportunity to permanently bring down Brazil’s historically high interest rates, which have consistently tracked well above both the inflation rate and above rates in emerging market peers, despite the fact that annual inflation rates are currently perilously close to the BCB’s 6.5% upper limit.
Nomura’s senior LatAm economist Tony Volpon highlighted a number of key takeaways from Copom’s minutes:
| First, the discussion of neutral rates suggests that the BCB is willing to “push the envelope” in discovering the limits of lower rates in Brazil... To do this right after last year’s inflation closed just barely below the top end of the current target is a bold move by the BCB. Second, the BCB appears to be sending a strong signal to the rest of the government about the importance of maintaining tight fiscal policy as a precondition for a lower neutral (and policy) rate. This also demonstrates the more coordinated nature of policymaking in the Rousseff administration, as a lower neutral rate involves not only fiscal-monetary policy coordination but also microeconomic reforms. |
The connection between rates and fiscal policy is crucial.
President Dilma has pledged to hit the government’s target of achieving a primary surplus of 3.1% of GDP in 2012, up from the previous target of 2.8%. Finance minister Guido Mantega reiterated the government’s determination to meet the target earlier this week, which he said would enable the central bank to continue to cut rates. “The budget cut will be enough to meet the fiscal target, keeping the current direction that makes room for a more elastic monetary policy,” he said.
However, many remain unconvinced that the government will achieve its fiscal tightening targets despite rumours that it will announce budget cuts in the coming weeks, especially given the slowdown in commodity demand and economic activity.
As Bank of America Merrill Lynch analyst David Beker noted in a recent research report:
| The BCB’s projections for 2012 work with the assumption that the government will deliver the full primary surplus (3.1% of GDP or BRL139.8bn) for the year. However, given the slowdown in economic activity, revenues are likely to decrease and meeting the full primary surplus target will be a tough task for government this year. As we have been noting for a while, the government will probably need to find extraordinary revenues to achieve the primary surplus. At this point, we forecast a 2.8% primary surplus (as a % of GDP) for this year, below the 3.1% target. |
However, with growth flatlining in Q3 11, and initial estimates suggesting that the economy may have contracted for a second quarter in Q4, analysts caution that the government may be tempted to scale back its fiscal tightening efforts in a bid to kickstart growth – a move that would make it harder for them to permanently bring down interest rates. Conversely, significant tightening could pave the way for more significant rate cuts.
Here’s Capital Economics’ Neil Shearing’s take:
| If Brazil is to exploit the global crisis to get interest rates down – and keep them down – then the government must resist the temptation to loosen the purse strings. There are rumours that a fiscal tightening will be unveiled over the coming weeks, but it is worth noting that it will need to be worth more than R$25bn (0.5% of GDP) just to offset the expansionary effect of this month’s 14% hike in the minimum wage (to which many benefits are indexed). As a rough guide, we estimate that for every R$25bn of fiscal tightening over and above the R$25bn baseline, interest rates could fall by an additional 25bps. Not for the first time, all eyes are now on the government. |
For the time being, Shearing expects the Selic to fall to 9.50% by the end of Q2, while Nomura’s Volpon believes the Selic will fall to 9.0% during the current rate cycle, though both acknowledge that these estimates could change significantly, depending on the interplay of growth and fiscal policy.
And Volpon, for one, is not optimistic that rates will remain in single-digits for long:
| As the economy accelerates in the second half, we see rates rising in early 2013, to the 11% region. We should once again witness single-digit policy rates in Brazil, but for them to remain there permanently will require further policy changes to bring the neutral rate even lower. |