Itaú BBA - Further interest rate cuts, Mexico surprises

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Further interest rate cuts, Mexico surprises

July 3, 2014

In June, monetary policy decisions were made in 23 countries under our coverage.

In June, monetary policy decisions were made in 23 countries under our coverage. Three countries – Hungary, Turkey and Mexico – and the euro zone reduced their benchmark rates. Mexico, which cut interest rates by 0.50 pp and signaled the movement as a one-off, was the greatest surprise. On the other side, Colombia and New Zealand increased their monetary policy rates, both continuing the tightening cycle of the last few months.

In Latin America, besides the Mexican surprise and the Colombian movement, Chile and Brazil were the highlights. The Chilean Central Bank maintained its downward bias, but one of its board members voted for a rate cut during its June meeting. In Brazil, the 2Q14 inflation report signaled  a stable Selic rate ahead.

1- Policy rates: Historical table

*Blank places mean absence of monetary policy decision for the month.

** Numbers in red indicate rate cuts, in green rate hikes and in grey another monetary policy change different from interest rates.

2. Charts

3. Monetary policy in LatAm

Brazil - Inflation Report: Current Monetary Policy Stance to Be Maintained

This morning, Brazil’s Central Bank Monetary Policy Committee (Copom) released its Q2 Inflation Report. In our view, the main goal of the report was to indicate that current monetary conditions are sufficient to bring inflation to a trend that converges to the target over the forecast horizon.

"The Committee anticipates a scenario that contemplates persistent inflation over the coming quarters, but if monetary conditions are maintained, inflation tends to converge towards the target in the final quarters of the forecast horizon." In this paragraph of the report, the Committee indicates stability of the Selic rate at the current level and alters the language of its last statements, where it had said that interest rates were being maintained "at the moment". In fact, the phrase "at the moment" does not appear in today's report.

This scenario in which inflation converges toward the target in the final quarters of the forecast horizon is supported by the central bank's forecasts, which show inflation receding considerably during the first two quarters of 2016. In the reference scenario (with constant interest and exchange rates), the central bank forecasts that the twelve-month IPCA will retreat from 5.7% at yearend 2015 to 5.1% in 2Q16. In the market scenario (market estimates for interest and exchange rates), the forecast stands at 5.0% in 2Q16, after closing at 6.0% at yearend 2015. For 2014, the central bank forecasts inflation at 6.4% in both scenarios.

In terms of economic activity, the Committee notes that the output gap "has been moving to disinflationary territory", as activity grows below potential. The Committee reduced its GDP growth forecast for this year from 2.0% to 1.6%.

Meanwhile, the Copom continues to forecast changes in the composition of growth over the medium term. In the Copom’s scenario, consumption expands at a more moderate pace, investments gain momentum and exports benefit from higher global growth and the depreciation of the real. On the supply side, the Copom assesses a more favorable outlook in terms of expansion of industry and agriculture, while the service sector tends to grow less than in recent years. This rebalancing, according to the Copom, suggests a demand composition more "favorable to potential growth."

Hence, the Committee admits the current economic slowdown, but mentions elements that are favorable to GDP growth over longer periods.

In short, the Copom indicates that new rate hikes are not needed ahead, as in the Committee's view inflation converges toward the target within the forecast horizon. Today's report will likely impact market expectations regarding the need to raise rates in 2015.

We maintain our forecast that the Selic rate will be stable at 11.0% until the end of this year. Despite today's inflation report, we believe that the Selic rate will increase to 12.0% in 2015, in order to ensure that inflation will converge to center-target.

Mexico - A Very Surprising Rate Cut

Mexico’s central bank decided to reduce the policy rate by 50 bps to 3.0%, in a very surprising move. No market analyst was expecting a cut in the most recent meeting or in the upcoming ones. The decision to cut was due to the disappointing 1Q14 GDP, amid well-behaved inflation and looser external financial conditions (that is, lower Treasury yields). While market participants (including us) were well aware of these factors, we read them as conducive to delaying the start of a hiking cycle, rather than to reducing rates. In the concluding remarks of the statement announcing the decision, the board limits the expectation for further cuts, by saying that it “estimates that additional rate reductions are not recommended in the foreseeable future, considering the expected recovery of the economy and the relative monetary policy stance of Mexico vis-à-vis the U.S.”

The minutes of the meeting show that the decision to cut the reference rate was not unanimous. Three board members voted in favor of reducing the reference rate by 50 bps while two voted to maintain the rate unchanged. One of the members who argued against an interest rate cut emphasized the possibility of new financial market volatility and its potential effect on inflation and financial stability. Furthermore, the expected economic recovery combined with the lags that monetary policy affects the economy would justify keeping the policy rate steady. The second dissenting member expressed his concern that a rate reduction would produce an ex ante negative real interest rate, which would discourage savings and foster excessive risk-taking. The expectation of higher interest rates abroad and the potential impact of a rate cut on exchange rate volatility also support the argument against a rate reduction, in his view. Finally, he too mentioned that a rate cut would impact the economy at a time when it would likely be recovering. 

We see rates remaining unchanged this year and a new hiking cycle at the end of 2015. However, the board’s commitment to keeping rates on hold is conditional on the economic recovery, in our view. If Mexico’s economy fails to rebound (which is not our baseline scenario) and the monetary policy stance in the U.S. continues to be loose, a further easing of monetary policy in Mexico is possible. 

Chile - Easing Bias Remains in a Split Board

Chile’s central bank left its policy rate unchanged at 4.0% in June, for the third consecutive month. Importantly, the board maintained the easing bias in the press statement announcing the decision, saying that it “will evaluate the possibility of introducing additional policy rate cuts according to the evolution of the internal and external macroeconomic conditions”.  

The minutes from the meeting revealed that board members were split on the decision to leave the rate unchanged at 4.0%. Overall, the majority of board members expressed that recent inflation surprises warranted a degree of caution regarding future policy moves, in spite of lower than expected growth. However, one board member voted to reduce the reference rate (by 25-bp), emphasizing the disinflationary impact of the economic slowdown.

In the monetary policy report for the 2Q14, the central bank reduced the GDP estimate for this year (to 2.5% -3.5% range), due to lower dynamism in private consumption and the poor investment numbers. As a result, the central bank maintained the easing bias, mentioning that the base scenario “uses a working methodological assumption where the policy rate will follow a path comparable to that deduced from financial asset prices”. This suggests that the central bank is considering one or two 25-bp rate reduction in its baseline scenario.

As Chile’s economy continues to be weak, we foresee the central bank resuming the easing cycle, with the interest rate ending this year at 3.5%. However, in our view, the easing cycle will only restart in 4Q14, once the board has seen clear evidence that the inflation outlook is no longer at risk.

Colombia - Tightening Cycle Continues and Dollar Purchase Program is Doubled

The central bank unanimously decided to raise the interest rate by 25-bp to 4.0%, in line with both our expectation and the market consensus. This is the third consecutive rate hike by the board as it maintains its approach to gradually increase the monetary policy rate now, to prevent the need for sharper interest rate adjustments in the future.

In addition, the central bank announced that it would continue its dollar purchase program, buying up to USD 2.0 billion from July to September. This is an increase from the USD 1.0 billion budget allocated for 2Q14. Thus, the central bank is trying to avoid an overheating of the economy and an appreciation of the currency at the same time.

We currently expect Colombia’s economy to grow by 4.5% this year and see the policy rate at 4.25% by yearend. However, considering the recent economic data, our scenario for both growth and the interest rate will likely rise for this year. Meanwhile, the central bank will probably continue to accumulate reserves to limit the impact of the tighter monetary policy on the peso, at a time when pressures on the exchange-rate are already strong for other reasons (the looser monetary policy stance in the U.S. and the higher weighting of Colombia’s domestic sovereign bonds in a benchmark index for local debt).

Peru - Rates Unchanged. For Now

The Peruvian Central Bank left the interest rate unchanged in June, at 4.0%. The press statement said that the decision to maintain the rate was consistent with an inflation forecast of 2.0% within the next two years, as inflation expectations remain in the target range and supply-side pressures continue to moderate. In this scenario, the central bank expects inflation to remain near the upper limit of the target band, thereafter converging to the 2.0% target. The board also considered the current below potential growth and the mixed signals of a global recovery in its decision, adding that the current indicators point to a temporary weakening of the economy, mainly due to the lower dynamism of investments and exports.

However, the reserve requirement rate was reduced to 11.5%, from 12%, effective from July after being on hold for the previous two months. Finally, the board reiterated that it would track inflation's evolution with respect to additional monetary policy moves.

We expect the central bank to reduce the policy rate by 25 bps in July. The central bank last reduced rates in November 2013 (to 4.0%). Since then, the economy has weakened, but the central bank chose to add stimulus to the economy by easing reserve requirements, as Peru’s economy is partially dollarized and the pressure for a stronger dollar globally was increasing. However, the available indicators for the second quarter show a much more pronounced slowdown. In our view, the recent activity numbers coupled with a looser monetary policy stance in the U.S. will likely convince the central bank to use its more traditional instrument (policy rates) to help the economy. We see the policy rate at 3.5% by the end of this year.

4. Calendar of monetary policy decisions in July

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