Itaú BBA - High inflation leads the Central Bank to signal rate hikes, but with caution

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High inflation leads the Central Bank to signal rate hikes, but with caution

April 1, 2013

Inflation remains under pressure, but some relief through tax cuts for basic food staples is likely to occur.

The Brazilian economy in March 2013

Inflation remains under pressure, but some relief through tax cuts for basic food staples is likely to occur. The Central Bank signaled that it would increase the interest rate, but cautiously, which in our view means an increase of at most 100 bps. The government continues to expand fiscal policy. The current-account deficit increased and will probably not be totally financed by foreign direct investment. Economic growth has recovered strongly in the first quarter. The government’s approval ratings hit all-time highs. But Infrastructure bottlenecks became more evident. In April, the focus will remain on inflation readings and on new policy measures.

Inflation remains under pressure…

The year-over-year reading reached 6.4%, close to the 6.5% upper limit of the target range. Furthermore, core inflation stands at 5.8%, and the share of products with positive price changes climbed to 74%. In order to curb inflationary pressures, the government cut taxes for the staple consumer products in the “cesta básica”, in a move that, according to our estimates, will shave a total of 0.20 p.p. off inflation in March, April and May. Inflation should break the upper limit of the range in March, hitting 6.6%.

… and the Central Bank signaled that it would raise the interest rate, but cautiously.

The Central Bank kept the benchmark interest rate unchanged at 7.25% in its March meeting, but indicated that the rate may be increased to curb inflation. It withdrew from its statement the indication that interest rates should remain stable for a “sufficiently long” period. However, the authorities reiterated that monetary policy should be “managed with caution.” We expect the tightening cycle to begin in May, at a pace of 25 bps per meeting, to a maximum of 100 bps. If there is unexpected relief in short-term inflation, the planned hike might not materialize.

The government keeps expanding fiscal policy…

In the 12 months through February, the primary budget surplus fell to 2.2% of GDP from 2.5%. Excluding atypical or temporary revenues and expenses, the result is even lower: 1.7% of GDP. The recovery in revenues remains slow, due to the gradual rebound in economic activity and the impact of tax breaks. Expenses are also rising, driven by administrative costs, particularly healthcare and education, and by government transfers, such as social programs.

… and the current-account deficit widened.

The current-account gap has been widening and already stands at 2.8% of GDP. One of the reasons is low activity in exports, which have been hurt by Argentina’s restrictions on Brazilian manufactured products and by internal logistical hurdles, which derail soybean shipments. Other factors are the rise in fuel imports and the rebound in profit and dividend remittances. From a long-term perspective, the increase in the current-account deficit could be explained by stabilization in terms of trade, in an economy where domestic demand rises faster than GDP. The current-account gap will probably not be totally financed by foreign direct investment.

Growth may pick up in the first quarter…

Signs of stronger growth, coming from agricultural, livestock and industrial activity, may drive GDP growth to 1.2% in 1Q13. But some of the factors behind it are temporary, such as inventory increases in some segments, particularly trucks. Fundamentals still point to moderate acceleration, with growth that is not widespread. The labor market remains tight, with the unemployment rate at historically low levels (5.4% after seasonal adjustment) and real wages rising briskly (2.4% over a year ago).

… and the government’s approval ratings reach all-time highs.

According to the latest IBOPE survey, the approval rating of President Dilma Rousseff rose to 79% from 78%. Among the areas with the best evaluation are policies to fight poverty and unemployment. On the other end, healthcare and public safety received the worst evaluations. The President also leads polls on voter intentions for the 2014 election, with 58%, according to Datafolha institute. In second place comes Marina Silva, who ran in the last presidential election, with 16%, followed by Aécio Neves, with 10%, and Eduardo Campos, with 6%.

Infrastructure bottlenecks became more evident.

Logistical problems have become more evident. The latest example is the lines of trucks trying to reach the Santos port, which prompted the Justice Ministry to forbid parking on the shoulder of the highway leading to the port. Such bottlenecks show the priority that must be assigned to the concession program for highways, railways, ports and airports to improve the economy’s functioning.

Equities fall, risk perception goes up.

The Bovespa benchmark index remained on a downward path, accumulating a drop of 1.9% in reais (-3.7% in dollars) in March. The 5-year CDS spread ended March at 137, climbing 3.4% from the previous month. The real weakened 1.9%, finishing at 2.01 reais per U.S. dollar.

What’s next?

The focus will remain on inflation readings and on the government’s policy reaction. Investors will monitor the impact of tax cuts on prices and signs from the Central Bank about the next steps in monetary policy.



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