Itaú BBA - Falling inflation paves the way for lower interest rates and a lower inflation target

Brazil Scenario Review

< Back

Falling inflation paves the way for lower interest rates and a lower inflation target

July 3, 2017

We reduced our inflation estimates to 3.3% from 3.7% in 2017, and to 4.0% from 4.1% in 2018.

Please open the attached pdf to read the full report and forecasts.

• Political uncertainty remains high, postponing reforms in Congress, amid a favorable international environment.

• Despite worsening domestic fundamentals, we maintain our year-end forecasts for the exchange rate at 3.50 reais per U.S. dollar in 2017 and 3.60 in 2018.

• We forecast GDP growth of 0.3% in 2017 and 2.7% in 2018, in line with a gradual recovery and slower advance of reforms.

• We reduced our inflation estimates to 3.3% from 3.7% in 2017, and to 4.0% from 4.1% in 2018.

• The National Monetary Council (CMN) lowered the inflation target to 4.25% in 2019 and 4% in 2020.

• Lower inflation paves the way for a longer cycle of interest-rate cuts. Our forecast for the Selic benchmark rate in 2017 remained at 8.00%, but the estimate for 2018 was revised downward to 7.50%.

Political uncertainty remains high, postponing discussions about the pension reform in Congress. The proposal awaits greater political consensus before being voted in two rounds on the floor of the Lower House and then moving on to the Senate. The process will likely take place only in the second half of 2017.

Doubts about the approval of the reforms heighten uncertainties surrounding the outlook for public-debt stabilization. The delay affects confidence levels and pressures domestic asset prices. Consequently, it weakens the outlook for a rebound in economic growth and, ceteris paribus, hinders a permanent decline in interest rates (which would result from the expectation of fiscal equilibrium), fueling growth in public debt. Without reforms, the government is less likely to meet the constitutional spending cap over time, and public debt is more likely to remain on an upward trend (see chart).

Amid greater uncertainty, meeting fiscal targets becomes even more challenging and the gradual reversal of Brazil’s fiscal imbalance should be delayed.

In 2017, we expect the primary deficit to reach 2.4% of GDP (158 billion reais), above the current target of 2.1% of GDP (142 billion reais). The fiscal need to comply with the target is estimated at 90 billion reais (1.4% of GDP). In this context, despite the already-significant efforts to freeze expenses and obtain extraordinary revenues (such as repatriation of funds held by residents overseas, concession auctions and several tax-amnesty programs), meeting the primary deficit target is an ambitious task. However, in light of the economic team’s strong commitment to the target, we do not rule out additional spending cuts (for instance, with an even-tougher spending freeze through the increase of unpaid commitments or “restos a pagar”) and higher revenues (through tax hikes, for instance), so as to compensate the disappointment in tax revenues. 

Our estimate for the primary deficit in 2018 is 2.1% of GDP (150 billion reais), which is also above the target of 1.8% of GDP (131 billion reais). Slower economic growth and difficulties in terms of cutting discretionary expenses further, raising taxes amid political uncertainty, and a third consecutive year of large extraordinary revenues tend to produce a more gradual convergence to primary budget surpluses that are compatible with stability in public debt.

Uncertainties surrounding reforms pressure the exchange rate, but external environment curbs losses

Notwithstanding political uncertainties, the Brazilian currency remained range-bound. The exchange rate fluctuated between 3.25 and 3.35 reais per dollar during the past month. Political events intensified uncertainties surrounding the approval of reforms, but risk premiums measured by CDS spreads remain well behaved. The main contribution to this behavior comes from the international scenario, which remains quite favorable to risky assets, ensuring a good performance by emerging-market currencies.

We maintained our exchange-rate forecasts at 3.50 reais per dollar in YE17 and 3.60 in YE18. On one hand, uncertainties surrounding adjustments and reforms became more intense, implying higher risk premiums. On the other hand, the international context is set to remain benign for a while, but the gradual reduction of global monetary stimuli will place moderate pressure on emerging-market currencies. The result would be a slightly weaker exchange rate than we see today.

The current-account deficit continues to narrow, driven by good trade-balance readings. Over 12 months, the deficit shrank to USD 18 billion, or 1.0% of GDP. In terms of financing, direct investment in the country remains robust, ranging from USD 80 billion to USD 85 billion since the beginning of the year, and is enough to cover the current-account deficit many times over.

We revised our estimates for external accounts in the coming years. On one hand, the downward revision in price estimates for some commodities exported by Brazil puts pressure on the 2018 trade balance. On the other hand, recent data show that profit and dividend remittances are thinner than anticipated. These drivers suggest a smaller current-account deficit, notwithstanding a weaker trade result. We forecast trade surpluses  of USD 60 billion in 2017 and USD 47 billion in 2018 (vs. USD 50 billion previously). For the current account, we forecast deficits of USD 19 billion in 2017 (vs. USD 23 billion previously) and USD 37 billion in 2018.

Economic activity: Improved figures in April; deteriorated expectations in June

The main economic figures advanced in April, signaling that a broader-based recovery in economic activity was materializing. Industrial production, core retail sales and real service revenues climbed 0.6%, 1.0% and 1.0% during the month, respectively. These readings beat expectations, and coincident indicators for May suggest another gain in industrial output.

Nevertheless, GDP is expected to post a small decline in 2Q17. Our forecast is -0.2% qoq/sa, due to a discrete retreat in agricultural GDP and unfavorable statistical carryover from several GDP components following weak results in March.

Higher-than-expected readings in April are offset by a less favorable outlook for June, given the sharp drop in confidence indicators (see chart). Indicators from confidence surveys with industrial, retail and service businesses declined 3.0%, 3.3% and 3.3% in June, according to FGV-Ibre. The drop was sharper in the expectations component, reflecting uncertainties surrounding reforms, as political turmoil increased.

We forecast GDP growth of 0.3% in 2017 and 2.7% in 2018, in line with a gradual recovery amid slower reforms. Progress in reforms (particularly the pension bill) could have led to a stronger recovery next year. On the other hand, a full stop in reforms could further delay the economic rebound, leading to slower annual growth.

Destruction of formal jobs was less intense in May. According to the Labor Ministry’s Caged registry, a net 34,300 formal jobs were created in May. The seasonally adjusted three-month moving average continued to show milder job destruction and retreated to -43,000 from -59,000 (see chart). The unemployment rate measured by PNAD fell to 13.0% in May from 13.1% in April (applying our seasonal adjustment).

Assessing the outlook for the labor market, the unemployment rate tends to remain on an upward trend and reach 14.0% by YE17 and 14.3% by YE18. We expect the unemployment rate to peak in 2H18, at 14.3%. Unemployment will continue to climb after the recovery begins, because the contracting cycle in economic activity has not yet fully impacted the labor market.

We lowered our forecast for 2017 inflation to 3.3%, from 3.7%

We lowered our forecast for the consumer price index IPCA in 2017 to 3.3% (3 pp lower than in 2016), from 3.7%. Most of the revision relates to lower estimates for food and fuel prices, reflecting more-favorable data at the margin, as well as adjustments in our expectations for some agricultural and oil prices. We expect year-over-year inflation to recede to 3.1% in June and to 2.8% in September, bottoming at 2.5% in August.

Breaking down the IPCA, we anticipate increases of 2.8% in market-set prices and 4.7% in regulated prices. Among market-set prices, we forecast a mild 1.0% advance for food consumed at home, after a 9.4% jump last year. The outlook for large crops in Brazil and other large global producers, amid favorable weather conditions, has been prompting declines in wholesale agricultural prices since September 2016 and affecting retail food prices favorably during this year. Sharp disinflation in food prices this year is set to provide relief of 1.4 pp to the IPCA reading – almost half of the estimated retreat in inflation during this period. For industrial prices, we expect an increase of 1.5% this year (4.8% in 2016). For services, our call stands at 4.6% (6.5% in 2016). Adverse conditions in the labor and real estate markets, dissipation of the inertia effect of past inflation, and a smaller adjustment in the minimum wage have moderated wage and rent costs. In that sense, they will contribute to lower service inflation in 2017. As for the main components of regulated prices, our forecasts are -5% for gasoline, 4% for medication, 7% for electricity, 7% for urban bus fares, and 13.5% for health insurance premiums.

We revised our estimate for 2018 inflation downward somewhat, to 4.0% from 4.1%, following a small adjustment in our forecast for regulated prices. Our estimates are 3.5% for market-set prices and 5.4% for regulated prices. The main driver for our below-target forecast for headline inflation next year is the negative output gap, along with smaller inertia from 2017 inflation and anchored inflation expectations.

The main risk factors for the inflation scenario remain tied to political issues. Greater uncertainty surrounding the political picture will hold back advances in reforms and needed adjustments in the economy, possibly causing additional impact on risk premiums and the exchange rate. Despite the negative effect on economic activity, setbacks in the approval process of reforms could also require alternative fiscal measures, such as higher taxes and/or reversal of tax breaks, with a corollary upward impact on inflation, at least in the short term. As for the external scenario, notwithstanding more favorable signs at the margin, there are still risks related to possible policy changes in the major economies which, eventually, could lift risk premiums and weaken the Brazilian currency.

Substantial slack in the economy may contribute to a sharper decline in inflation. The negative output gap (difference between potential and effective GDP) and a high unemployment rate for a longer period may prompt faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial products. Inflation readings in recent months showed evidence of a more widespread disinflation process, which has been affecting these segments in particular. As for prices for food consumed at home, given the favorable supply shock and the recent evolution of wholesale agricultural prices, we cannot rule out an even more beneficial behavior than our current call.

A lower inflation target for 2019and 2020 reinforces the outlook for lower inflation results and anchored expectations. The median of inflation estimates, measured by the Central Bank’s Focus survey, declined to 3.5% from 3.9% in 2017 and to 4.3% from 4.4% in 2018. Median estimates for 2019 and 2020 remained at 4.25%. In fact, in its meeting late last month, the CMN confirmed expectations and reduced the inflation target for the 2019 and 2020 calendar year.

Monetary policy: Future steps depend on scenario developments

The National Monetary Council set a lower inflation target for 2019 and 2020 of 4.25% and 4% respectively. The decision has no significant implications for the monetary-policy stance, given that inflation expectations already incorporated a lower target. However, the new target helps anchoring long term inflation expactations and signals an eventual convergence for even lower inflation levels over time.

Forecasts in the Central Bank’s Inflation Report for 2Q17 are consistent with a continuing easing cycle, with the Selic rate moving toward 8.5%-8.0% by year-end, as indicated by the Focus survey. Inflation estimates for 2018 (the relevant horizon for monetary policy) are below the target in three out of four scenarios presented by the Monetary Policy Committee (Copom). Forecasts for 2019, which will become ever more important in committee discussions, range from 3.8% to 4.3% – thus below the current 4.5% target and consistent with the reduction of the 2019 target to 4.25% by the CMN. Importantly, these forecasts seem to contain above-consensus estimates for regulated prices and, thus, may retreat over time.

However, in our view, lower inflation (with a benign composition) and weaker activity will push the Central Bank toward a longer easing cycle. We expect the Selic at 8.00% by YE17, and reduced our forecast for YE18 to 7.5% from 8.0%.

According to the Inflation Report, the next Copom decision may be either a 75- or 100-bp cut in the Selic rate. In fact, the text refers to the signaling of deceleration, presented in the latest policy meeting statement and minutes, in the past tense, thus corroborating the possibility of sustaining the easing pace at 100 bps in the July 25-26 meeting.

Given the heightened uncertainty in the scenario, we stick to the view that the Copom will cut the Selic rate by 75 bps, to 9.5%, in July, instead of opting for a more aggressive reduction. However, further disappointment with the economic recovery and benign inflation surprises could convince the Copom to keep the faster easing pace, particularly if political uncertainties cool off and reforms go back to the table.


 


 

Please open the attached pdf to read the full report and forecasts.



< Back