Itaú BBA - Inflation continues to fall, Central Bank increases pace of easing

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Inflation continues to fall, Central Bank increases pace of easing

April 13, 2017

With lower, current and expected, inflation, the BCB has increased the pace of easing to 100bps.

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

GDP is likely to show positive growth in 1Q17, driven by high agricultural output.

• Congress will debate Social Security reforms in April. We expect the reforms to be approved in 3Q17.

• We have maintained our exchange rate forecast (BRL 3.35 to the dollar at end 2017 and BRL 3.45 to the dollar at end 2018). 

• We have reduced our IPCA inflation projection for this year to 3.9% (from 4.1%). Our 2018 forecast is unchanged at 3.8%.

• The central bank increased the pace of interest rate cuts. We expect the Selic rate at 8.25% by the end of 2017 and 2018.

Agricultural output set to ensure positive GDP growth in 1Q17

Industrial activity stagnated at the start of 2017. Industrial output fell 0.2% in January, rose 0.1% in February and we are forecasting a new 0.6% retreat in March. 

However, the significant increase in soybean and corn production compared with 2016 and the positive carryover from industrial output indicate positive GDP growth in 1Q17. We estimate agricultural GDP will make a direct 0.9 p.p. contribution to GDP growth in 1Q17 year-over-year growth, driven by a 46% increase in the corn crop and 16% bump in the soybean crop. Additionally, any slight drops in industrial output throughout the quarter have been insufficient to offset the effect of the substantial December increase in the quarterly comparison (see graph).

Methodological changes in the monthly retail and service surveys published this week further support GDP growth in the first quarter. Our 0.5% GDP growth forecast in the quarter will likely be revised upward soon as we incorporate recent data.

Some leading indicators suggest more widespread growth. Main confidence indicators remain on the rise and this improvement is based not only on improving expectations, but also a better assessment of the current situation (unlike the second quarter in 2016). Furthermore, the recent drop in inflation has slowed real household income contraction, while cash withdrawals from inactive accounts in the Severance Pay Fund (Fundo de Garantia do Tempo de Serviço) will improve families’ finances and encourage consumption. These factors may be temporary, but they are having an effect on activity before interest rate cuts affect aggregate demand.

We are therefore maintaining our forecast of 1.0% growth in 2017 GDP and a 4.0% increase in 2018.

Formal job losses continue to slow. February saw net creation of 35.6 thousand formal jobs (according to figures from the payroll job report - Caged). Stripping out seasonal effects, the three month moving average improved to -35 thousand from -62 thousand. We expect ongoing net job destruction until the second half of this year. However, hiring, which usually reacts before net job creation, posted the fifth consecutive increase on the margin, indicating that job destruction should continue slowing over the coming months.

Despite better Caged numbers, the nation-wide unemployment rate rose to 13.2% in February, compared with 12.6% in January. The unemployment rate (stripping out seasonal effects) registered its 27th consecutive increase and rose to 13.1% from 13.0% (our estimates). Incorporating the recent job market dynamics, we have increased our unemployment forecast to 13.8% at the end of 2017 (previously 13.4%) and to 13.6% in the fourth quarter of 2018.

Fiscal: focus on Social Security reform

In April, the Lower House Special Committee will continue debating the Social Security reform bill (PEC 287/16). Rapporteur Arthur Maia (PPS-BA) is expected to present his report in the second half of the month and it will be debated in Congress by House representatives, senators and the government until the end of the third quarter of 2017.

The government’s original proposal would have had an impact on the federal government’s primary result equivalent to 2.0 p.p. of GDP in 2025, compared with the scenario in which no reform is approved. On the spending side, the proposal saves equivalent to 1.5 p.p. of GDP by adapting Social Security benefits access rules to current fiscal realities and Brazilian demographics. On the revenue side, there would be gains equivalent to 0.5 p.p. of GDP, mainly because people will continue working and making Social Security contributions for a longer period of time.

However, the government has announced that rapporteur Arthur Maia’s (PPS-BA) report will propose changes to five points in the original proposal. The rules governing rural workers’ pensions, special pensions for teachers and police, the social assistance benefit (BPC) included in the Social Welfare Framework Act (LOAS) and survivor pensions are unlikely to be modified (or, at most, face small adjustments compared with current rules). Additionally, the transition rule towards a minimum retirement age of 65 – which has the biggest fiscal impact of any measure included in the reform – will be different from government’s original proposal[1] .

We believe Congress will approve the Social Security reforms, but their impact will amount to 1.2 p.p. of GDP, or 60% of the amount originally proposed by the government (see Graph). The dilution in the transition rule will take away 0.4 p.p. of the expected GDP gains (or 20%) compared with the original proposal, while changes to other benefits (see above) will take away a further 0.4 p.p. of GDP (or 20%) from the original reform total impact.

Even if the proposals are diluted to this extent, approving the Social Security reforms will be a critical step toward stabilizing medium-term public debt. No reforms or even laxer rules would increasingly undermine the government’s long-term ability to adhere to the spending cap and public debt growth would remain unsustainable. We are forecasting that a return to primary surpluses will only be achievable again in 2020, however we believe a return to growth and a drop in interest rates following the adoption of reforms, which could be persistent, will significantly reduce the pace of public debt increases each year. We forecast that public debt will remain stable at around 80% of GDP from 2018 onwards.

We expect a primary deficit of 2.2% of GDP in 2017 (BRL 142 billion), in line with the fiscal target. In order to address uncertainties around this year’s fiscal target, the government has announced BRL 42 billion in discretionary spending cuts and is reverting tax exemptions, including those from payroll Social Security contributions. We believe the spending cuts could be gradually rolled back as the year progresses, with additional revenues accruing from judicial bonds (“Precatórios”) as well as energy and transportation concessions, in addition to positive surprises from economic growth with respect to the government’s current outlook (we expect to see 1.0% growth, whereas the government is projecting just 0.5%).

In 2018, we forecast a primary deficit of  1.7% of GDP (BRL 122 billion), slightly lower than the announced target of 1.8% GDP (BRL 131 billion). Compared with our previous expectations of a deficit of 1.6% of GDP (BRL 117 billion), our forecast for state and municipal governments has worsened by BRL 5 billion, given that the stated target of a BRL 1 billion primary surplus would allow the government to pay budget leftovers when the economy returns to growth. This forecast takes into account better economic growth than currently envisaged by the government (we forecast 4.0% growth compared with the government’s 2.5% estimate), the spending cap (approved in 2016) and BRL 15 billion (0.2% of GDP) in extraordinary revenues, which are compatible with a gradual reversal of Brazil’s fiscal imbalance.

All-time high trade surplus in the first quarter of the year

The trade surplus marked an all-time high in the historical series (since 1992) in 1Q17. Imports have been showing some signs of recovery (especially in year-over-year terms), though growth has not been consistent yet.This, along with higher prices for key commodities exported and increasing export volumes for a number of basic items (particularly oil and fuel, iron ore and soybeans), has ensured all-time high trade surpluses in the first quarter of the year.

We have increased our trade surplus forecast for 2017 and 2018. This mainly reflects rising oil and fuel exports. We forecast a US$ 52 billion trade surplus[2] in 2017 (previously US$ 49 billion) and US$ 37 billion surplus in 2018 (previously US$ 35 billion).

However, the current account deficit will increase over the next several years. We forecast a US$ 30 billion deficit in 2017 (previously US$ 32 billion) and US$ 52 billion deficit in 2018. We expect the combination of a slightly more appreciated exchange rate (in real terms), recovery in domestic demand and commodity prices below current levels to result in weaker figures in the coming months.

We continue to forecast an exchange rate of BRL 3.35 to the dollar at end 2017 and BRL 3.45 to the dollar at end 2018. US interest rates increases throughout the year and commodity prices drop from their current levels justify currency depreciation from current levels. This exchange-rate trend is in line with a scenario of slight growth in current-account deficits, albeit at low levels, not compromising external sustainability. 

We have reduced this year’s inflation forecast to 3.9%

For this year, we have reduced our 2017 Extended National Consumer Price Index (IPCA) inflation forecast to 3.9% from 4.1%. This revision takes into account a reassessment of forecasts for food at home and industrial prices, amidst more favorable results on the margin, principally in the wholesale prices. On a cumulative, twelve-month basis, we expect inflation to fall back to 4.1% in April; 3.8% in June; and 3.6% in September. We note that disinflation tends to trigger a welcome debate about reducing the inflation target. The National Monetary Committee (CMN) will meet in June to reassess 2018’s 4.5% inflation target and set the target for the following year.

On a disaggregated basis, we are forecasting a 3.4% rise in market prices (previously 3.7%) and a 5.3% increase in regulated prices (previously 5.5%) for 2017. Looking at market prices, we have reduced our inflation forecast for food at home to 2.0% from 2.3% based on more positive results in wholesale farm prices. The agricultural products from the Wholesale Price Index (IPA) published by the Getúlio Vargas Foundation (FGV) has been negative for seven consecutive months, retreating a cumulative 9.4% between September 2016 and March this year. After ending the last year up 9.4%, the 12-month change in the food at home subgroup ended the first quarter up 3.0%. The likelihood of bumper farm crops in Brazil and the world’s other main producer countries as weather conditions improve is likely to result in wholesale farm price deflation as the year progresses and, as a result, ensuring that food prices behave well throughout the year. Strong food price disinflation this year, a result of the positive supply shock, should reduce the IPCA by 1.2 p.p., equivalent to half the forecast drop in this year’s inflation. We have also revised down our forecast for industrial prices, to 2.3% from 2.8% (compared with 4.8% in 2016) as a result of lower-than-expected results at the margin in both the retail and wholesale markets. For services, we have maintained our forecast of 4.9% for this year (compared with 6.5% in 2016). The labor market and real estate sector continue to face strong headwinds and there has been a reduced inertial effect from past inflation and a smaller increase in the minimum wage, all of which has had a moderating effect on wage and rent costs and will contribute to a further fall in service inflation this year. Looking at regulated prices, we are forecasting a 1% drop in landline bill prices; no change in gasoline prices; 4% rise in drug prices; 7% rise in urban bus services; 7% rise in electricity; 8% rise in bottled gas; 8% rise in water and sewage rates; and an 11% rise in health plans. Looking specifically at electricity, we have reduced this year’s forecast of a tariff increase; however, we are now working under the hypothesis that the yellow tariff flag will be triggered by yearend given worsening hydrological conditions.

Our 2018 inflation forecast remains stable at 3.8%. On a disaggregated basis, we are forecasting a 3.5% rise in market prices and a 4.7% increase in regulated prices. The output gap, which is still in negative territory, lower inertia from this year’s inflation and stable inflation forecasts will be the main drivers behind forecasts of below-target inflation next year. As noted above, instances where inflation dips below the target center in the 2Q17 create an opportunity to discuss reducing the inflation target for the years ahead. We believe that a lower target will be credible and help support the process of reducing the level of inflation to levels close to our peers.

The main risk factors to the inflation outlook are linked to external scenario uncertainties and, more particularly, domestic political issues. Greater external uncertainty, reinforced by recent geopolitical tensions in the Middle East and Asia, could see risk premiums increase, which may result in further exchange-rate depreciation. Special attention should be paid to the possibility of a faster rise in US interest rates than initially considered. In fiscal terms, any further difficulties moving ahead with the necessary reforms and adjustments could create apprehension on the markets and have an additional impact on risk premiums and exchange rates and require alternate fiscal measures, such as tax hikes. As far as progress on reforms is concerned, the difficulties that have arisen in accepting the original Social Security reform bill suggest the government needs to negotiate harder to achieve approval.

The high level of idle capacity in the economy may help push down inflation further. The negative output gap (the difference between potential GDP and actual GDP) could lead to faster market price disinflation over the next few months, particularly in areas that are more sensitive to the economic cycle, like industrial goods and services. Downside inflation surprises in recent months offer evidence that there is a more widespread disinflation process across precisely these segments. This means that progress on fiscal reforms could improve the outlook for inflation, either through the exchange rate and inflation expectations channels, or by gradually switching from expansionary to neutral or even contractionary fiscal policies.

A lower target would help anchoring expectations and support forecasts for falling inflation. According to the Central Bank’s Focus survey, median inflation expectations for 2017 retreated again last month to 4.09% from 4.36%. In turn, median expectations for 2018 fell to 4.46% from 4.50%, a level that is slightly below the center of the target. Finally, median inflation forecasts for 2019 to 2021 point towards inflation at 4.25%, which likely takes into account the possibility of a lower target for the 2019 calendar year, which the CMN will set in June.

A faster pace of interest rate cuts for now

At its April monetary policy meeting, the Central Bank cut interest rates by 1.0 p.p. reducing the Selic to 11.25%. In the statement accompanying its decision, the central bank signaled that the length of its monetary easing cycle will depend on estimates of structural interest rates in the Brazilian economy, but also on the behavior of economic activity, inflation forecasts and expectations and other risk factors. The statement also indicates that, for the moment, 100bps is the preferred pace of easing.

We forecast the Selic rate at 8.25% by the end of 2017 and 2018. We expect one more 100-bp cut in May, two cuts of 75 bps (in July and September), and one cut of 50 bps (in October).



[2] As reported by the MDIC


 

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



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