Itaú BBA - Selic Rate at One Digit: What Lies Ahead?

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Selic Rate at One Digit: What Lies Ahead?

February 8, 2012

With the Selic rate now on a firm path to a level at or close to 9%, the next relevant question is: Where will it go next year?

We reaffirm our view that the Selic rate, now at 10.5%, will be lowered to 9% in 50-bp rounds over the coming months. As growth increasingly creates inflationary pressure, we expect interest rates to rise again, reaching 10.5% (previously 11.5%), and to see prudential measures adopted again in early 2013 (previously not included in our scenario). Our other key forecasts are unchanged: we see GDP growth at 3.5% in 2012 and 5.4% in 2013. IPCA inflation will likely fall to 5.2% this year and pick up again to 5.6% in 2013. We remain optimistic about capital inflows, and expect the exchange rate to be 1.75 reais to the dollar at year-end.

The allusion to a “one-digit” scenario in the Central Bank’s January policy minutes, coupled with signs that the Central Bank is comfortable with the inflation outlook, suggests that the Selic rate will really cross below 10% in the coming months.

We have been expecting it to reach 9%. The Central Bank might prefer to stop before that – at 9.5%, let’s say– especially if global risks look smaller. Still, a Selic rate between 9% and 10% will produce very low real rates and boost growth.

 What’s Next? Will the Selic Rate Go Back Above 10%? 

Any answer to this question depends on an assessment of future growth, inflation and how stimulative fiscal policy could become. It also depends on the recently revived debate over “equilibrium real interest rates” in Brazil.

Growth will probably continue to rebound. Recent data points to a recovery after weak growth in the second half of 2011. Industrial production rose by 0.9% mom/sa in December, with a strong pickup in the auto sector and also in the white goods sector (major appliances), which was benefited by tax breaks in the beginning of the month. Retail sales also picked up and will likely continue to do so as the new minimum wage, effective from January, spreads across the economy.

It is true that auto production fell by almost 10% mom in January, suggesting that manufacturing has stalled again. Inventories have only now started to decline. But looking ahead to the next few months, it is reasonable to expect that rising demand will gradually push up supply. We maintain our view that GDP will grow by 0.8% qoq/sa in the first quarter, with growth speeding up later in the year. Our 2012 growth forecast remains at 3.5%.

The IPCA index will likely show less inflation in coming months, and we expect it to close the year up 5.2% — lower than in 2011, but still above the target’s midpoint. However, the pickup in growth, especially in the second half of the year, will likely cause inflation to rise again in 2013. The inflation consensus for next year is already at 5.0%. Our estimate is 5.6%.

Fiscal policy will help growth too. We expect that the new minimum wage and increased investment will fuel public spending, reducing the primary surplus to around 2.5% of GDP (from 3.1% in 2011). Could this story be different?

We tend to think that the fiscal restraint in 2011 was a cyclical response, to be reversed when growth is needed again. But could fiscal policy become permanently more austere?

That is the government’s stated intention. Such a policy — including, for example, meeting the 2012 fiscal target in full — would certainly help to hold back excess growth and inflation, reducing the need for rate hikes in 2013. But it will be difficult to deliver, especially in light of this year’s strong hike in the minimum wage and increase of public investment.

Indeed, spending was already rising in December. After four months of stability, total federal outlays went up 10% yoy in real terms, boosted by administrative and capital spending. We expect real expenditures to speed up to 8.5% in 2012 (from 3.5% in 2011), bringing the primary surplus down to around 2.5% of GDP (from 3.1% in 2011), assuming extraordinary revenues of 0.3% of GDP.

It must be said that, after this year’s massive rise, the minimum wage will climb more moderately in 2013 – by around 8%, if our growth and inflation forecasts are right.

In its latest policy minutes, the Central Bank referred to a single-digit Selic rate in the context of a decline in “equilibrium real rates.” In the Central Bank’s view, Brazil’s history of macroeconomic adjustment has boosted credibility and reduced the country’s risk, pushing the “neutral real rate” down.

In our view, the neutral real rate has indeed fallen, thanks to improving fundamentals (foreign savings, financial deepening, public debt and lower risk perception). The exchange rate appreciation can be an indication of an increase in foreign savings funding domestic investment. As foreigners increase their demand for Brazilian assets, a lower real interest rate is required to balance savings and investments. Financial deepening and lower public debt are symptoms of development and lower risk.

Considering these and other factors, we estimate that Brazil’s equilibrium real interest rate is now around 6%. It may actually be lower than that. Those estimates are sensitive to fiscal policy, so the equilibrium rate may fall faster if the government holds back spending growth in the coming years.

As a result, whenever the Selic rate does go up, it will likely go up by less than in the past. Fresh inflation pressures will likely push the Central Bank to raise the Selic rate again. Our models suggest that keeping inflation around 5.5% next year is consistent with the Selic rate rising to 10.5% (starting in March 2013, with two hikes of 50 bps, followed by two of 25 bps), provided that the Central Bank also reinstates “macroprudential” measures.

Unemployment: What’s Happening? 

The 2011 slowdown significantly reduced job creation in the second half of the year, but unemployment did not rise. In the formal sector, for example, we estimate that job postings are now being added at an annualized pace of 3.3%, down from 6.5% one year ago. And yet the unemployment rate fell to 5.5% (seasonally-adjusted) in December of 2011 from 6.2% one year earlier.

The economy slowed throughout the first half of 2011, came to a complete halt in the second half, and still the unemployment rate did not move an inch. There is more than just a lag at work here. Why is the unemployment rate so low?

One possible reason is that the labor force is growing more slowly than the total population. New workers are more scarce and less skilled. Labor productivity may be going down too. A slow-growing working population is common in aging societies. In Brazil (still a young society, though certainly not as young as 20 years ago), the effect is probably magnified by shortcomings in education, and by the fact that the economy is growing towards the labor-intensive services sector.

Low unemployment as a reflection of low productivity is not good news. Among other things, it creates more inflation risk whenever the economy recovers.

A second possible reason is labor hoarding. Firms may have come to prefer keeping workers during a downturn, as an insurance against higher wages when the economy recovers. The 2009 experience is a case in point.

These two phenomena are probably occurring alongside one another, though labor hoarding seems to be the smaller problem: when the economy recovers, unemployment is held back with less inflationary risks.

Both of these trends – low productivity and labor hoarding – will tend to hold down unemployment through a downturn, but they cannot eliminate the lag effect. We still expect the unemployment rate to go up, just less than we expected before. It will probably stay at around 5% and 6% in 2012-13 – lower, therefore, than our previous forecast of 6%-7%.

 The Balance of Payments Remains Strong

The external accounts remain healthy. Domestic growth prospects continue to attract a considerable amount of foreign direct investment, which added up to 2.7% of GDP in 2011. Additionally, net external borrowing reached 1.9% of GDP. The two combined provided comfortable financing for a current account deficit of 2.1% of GDP. We believe that those more structural inflows will continue in 2012, keeping the balance of payments in a fairly strong position. On the other hand, the government should continue to intervene in the FX market to prevent the currency from strengthening more. We maintain our year-end exchange rate forecast of BRL 1.75 per dollar.

Nevertheless, 2012 should also witness a declining trend in the trade surplus. The domestic economy is likely to grow faster than in 2011 while the global economy expands more slowly. And the terms of trade could be less favorable, reflecting lower commodity prices. Thus, we expect the trade surplus to fall to USD 11 billion in 2012 from USD 29 billion in 2011, pushing the current account deficit up to 3.0% of GDP.

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