We maintain our call for a 0.75pp cut next week
• The Brazilian Central Bank’s Monetary Policy Committee (Copom) will meet again next week. Recent data show an environment of low inflation and anchored expectations, with signs of a still gradual, but increasingly broader, recovery of economic activity. Copom’s inflation forecasts will likely be unchanged for 2017 and slightly lower for 2018, compared to BCB’s most recent inflation report.
• According to recent communication from the monetary authority, we expect the Copom to reduce the easing pace to 0.75pp, which would represent a moderate pace reduction from the 1.00pp cuts implemented in the last four meetings. This decision would be consistent with the committee’s recent signaling, considering the evolution within expectations of the baseline scenario and the current stage of the easing cycle.
• In the post-meeting statement, we expect the committee will continue signaling the continuity of the easing cycle and further reduction of the easing pace at the December meeting, if the conditions described in the baseline scenario are maintained.
• We maintain our call for a 0.75pp cut next week, followed by two 0.50pp reductions in the December and February meetings, bringing the Selic rate to the final level of 6.5%.
1 – Recent data
Recent inflation data showed ambiguous results. The mid-month IPCA-15 rose 0.11% in September, below market expectations. The September IPCA index, on the other hand, increased 0.16%, above expectations, influenced by the transportation group (0.14pp), due to the pressure on fuel prices and airfares. In particular, service inflation (an item of special interest for monetary authorities) remains low, reflecting the still substantial slack in the labor market. Finally, October’s IPCA-15 came in line with expectations, bringing the 12-month consumer inflation rate to 2.71% (from 2.56%). Wholesale price indexes continue to decline year-over-year, due to the sharp drop in agricultural commodity prices.
Economic activity posted weaker results in August, with downward surprises from industrial production, retail sales, real revenues from services and the labor market. Despite the deterioration at the margin, the broad set of economic indicators continues consistent with a gradual economic activity recovery . Industrial production fell 0.8% in the month, interrupting a sequence of four consecutive increases. The breakdown shows a more favorable situation than the aggregate result, as the decline in August was influenced by the extractive industry, and both capital goods and consumer durable goods continued to advance at the margin. The first coincident indicators (industry confidence, utilization of installed capacity, weekly data on foreign trade and energy consumption, preliminary results of the auto sector, among others) signal a 0.6% increase in industrial production in September.
In the labor market, there was formal job creation in September, albeit below expectations. In seasonally-adjusted terms, there was a net destruction of 21.6 thousand jobs, taking the three-month moving average to -12 thousand (from -13 thousand in the previous month). According to IBGE, the national unemployment rate dropped to 12.6% in August, from 12.8% in the quarter ended in July. Using our seasonal adjustment, unemployment fell for the fifth consecutive month, to 12.6% from 12.7%. The trend continues to be largely influenced by informal employment, but formal employment in the private sector contributed positively for the first time in the current cycle. Finally, service-sector activity and retail sales also moderated at the margin in July, pointing to a temporary respite from above-expectation results in recent months.
On the fiscal side, the successful energy sector auctions and the partial withdrawal of “precatório” deposits in September reduced the risk of not reaching the about R$ 44 billion in extraordinary revenues that are necessary to meet the year’s target of a R$ 159 billion (or -2.4% of GDP) central government primary deficit. In addition, the government announced its intention to anticipate the return of R$ 180 billion (2.5% of GDP) from BNDES to the National Treasury, as a way to mitigate the impact of high primary deficits on gross public debt. However, in order to permanently reverse the currently unsustainable trajectory of public debt, the approval of reforms is paramount. Without the reforms, there would be heightened chances of the government failing to comply with the spending cap from 2019 onwards, and the gradual return to surpluses compatible with the stabilization of public debt would become unlikely. In particular, the pension reform continues to await greater political support for a two-round vote in the Lower House plenary and subsequent submission to the Federal Senate.
2 – Inflation forecasts
Copom’s inflation forecasts, considering the interest rates and exchange rates reported by the Focus survey, will likely be unchanged for 2017 and slightly lower for 2018 compared to BCB’s most recent inflation report, in a context of more appreciated exchange rates and substantially lower inflation expectations.
Since the September meeting, inflation expectations for 2017 fell by 0.38pp to 3.00%, while for 2018 there was a 0.16pp decline to 4.02%. Expectations for the Selic rate fell from 7.25% to 7.00% for 2017 and from 7.50% to 7.00% for 2018. As for the exchange rate, expectations point to more appreciated rates, at 3.15 reais per dollar in 2017 and 3.30 in 2018 (compared to 3.20 and 3.35 reais per dollar, respectively, at the September meeting).
The table below summarizes the estimates based on our model, which attempts to replicate the BCB’s small-scale model. We estimate that, compared to the scenario presented in the most recent IR, the inflation forecasts presented to Copom will likely remain stable at 3.2% for 2017 and recede from 4.3% to 4.2% in 2018.
In the most recent IR, the committee presented inflation forecasts up to 2020. We estimate that the 2019 projection, which will gain more importance for the Copom’s deliberations from the beginning of next year, will likely stay at 4.2%, close to the inflation target of 4.25%. For 2020, the forecast is also likely to remain stable at 4.1%, around the inflation target of 4.0% for this year. The fact that the forecasts for 2019 and 2020 are close to their respective targets, assuming market interest rates, indicates that interest rates may remain at low levels for an extended period.
3 – Communication changes and the Copom-o-Meter
In the statement and minutes of September’s Copom meeting, the committee signaled that the evolution of the economic situation – that is, the consolidation of activity stabilization followed by a gradual recovery, with substantial labor market slack and favorable evolution of the inflation outlook – and of the balance of risks was compatible with reducing the Selic rate to 8.25%, which would be consistent with the convergence of inflation to the target within the relevant horizon for monetary policy. In addition, the committee observes that the economic scenario prescribes stimulating monetary policy, that is, interest rates below the structural rate, and recognizes the necessity of the continuity of the reform agenda in order to guarantee the sustainability of this reduction in real interest rates.
Looking ahead, the committee indicated that if the baseline scenario evolves as expected, and (importantly) due to the stage of the easing cycle, it would be appropriate to have a moderate reduction in the magnitude of monetary easing – that is, a gradual path to the Selic rate, which in our view,will reach 7.0% by the end of 2017.
In its communication, the Copom also pointed out that monetary policy needs to maintain flexibility to react both to downside and upside risks for inflation. The comitee specifically mentioned the downside risks arising from the drop in food prices and the spread of currently low inflation through indexation and the upside risks that stem from the chance of a reversal in the benign external scenario, leading to higher inflation and frustration of expectations about the continuity of reforms, which has the potential to affect risk premiums and raise the inflation path in the relevant horizon for monetary policy.
In trying to anticipate the Copom’s decisions based on BCB’s communication, we use the Copom-o-Meter, an index that measures the level of implicit policy contraction or easing in BCB’s communication. Applying the methodology, we understand that the tone of the communication adopted and its evolution reinforce our view of a moderate reduction in the easing pace to 0.75pp in the next decision.
4 – Our view
We expect the Copom to reduce the Selic rate by 0.75pp at the October 24-25 meeting. The pace of reduction, compared to the 1.00pp cut implemented in the last four meetings, is compatible with the recent signaling of the committee, according to which, if the baseline scenario evolves as expected, and given the stage of the easing cycle, a moderate reduction in the magnitude of monetary easing would be adequate. Recent speeches by members of the Copom have been highlighting, in our view, that the baseline scenario for inflation has not changed substantially since the last meeting, and since the signaling of moderation presented in the Inflation Report released by the BCB on September 21. This context consolidates our call for a 0.75pp cut next week.
In the statement, we expect the committee to continue to signal continuity of the easing cycle, as we still see the 2018 inflation forecast slightly below the target. But, consistent with Copom’s signaling that it anticipates a gradual completion of the easing cycle, we expect further reduction in the easing pace to be signaled for the December 5-6 meeting, if the conditions described in the baseline scenario are maintained. As usual, the committee will also likely point out that the easing pace will continue to depend on the evolution of economic activity, the balance of risks, possible reassessments of the estimated length of the cycle, and inflation forecasts and expectations. Our scenario continues to be a 0.50% cut at the Copom meeting in December.
We do not expect the Copom to indicate the end of the cycle at the present moment, as inflation forecasts are still below the target for 2018. In particular, we do not expect any signaling regarding the decision of the first Copom meeting in 2018, on February 6-7. Our scenario, however, continues to be an additional 0.50pp reduction in February, which would mark the end of the easing cycle with the Selic rate reaching the final level of 6.50%.