Itaú BBA - South America in easing mode

Global Monetary Policy Monitor

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South America in easing mode

January 4, 2017

Despite the outlook for a more austere monetary policy in the U.S., South American central banks are cutting interest rates.

In December, monetary policy decisions were made in 23 of the 33 countries we monitor. For the first time since February 2016, there was a larger number of central banks raising interest rates than cutting interest rates. Among the developed countries, we highlight the 0.25-pp increase in the U.S. monetary policy rate and the European Central Bank's decision to extend its asset accumulation program for nine months, but with a slower pace of purchases (60 billion euros per month, instead of the current 80 billion).

Despite the outlook for a more austere monetary policy in the U.S. (partly related to the expectation of a more expansionary fiscal policy in that country), many South American economies are currently undergoing monetary easing cycles. In Chile, the central bank maintained the monetary policy rate unchanged in December but introduced an easing bias, while in Colombia the beginning of an easing cycle took place in December (earlier than expected by the market). In Brazil, we expect an acceleration in the pace of interest rate cuts in January (to 0.50 pp per meeting). Conversely, in Mexico, the exchange rate depreciation and the increase in gasoline prices will further pressure inflation, while the central bank continues to monitor closely the Fed’s moves. So the Mexican central bank hiked the interest rate by 0.50 pp in December (exceeding the market’s consensus estimates).


 

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

ARGENTINA – New reference rate debuts in 2017

Because inflation expectations for 2017 are not converging to the target range, the monetary authority left its new reference rate (7-day repo rate) unchanged, at 24.75%, in the first week of January. Throughout December 2016, the central bank also kept the reference rate (then, the 35-day Lebac) unchanged.The central bank started to use the center of seven-day repo-rate range as the monetary policy instrument in 2017. Although we do not expect inflation to end this year within the target range, we think rate cuts this year are likely. 

The new reference rate will be announced weekly, just like the Lebac rate was. The range for this rate is delimited by the central bank’s lending rate (active repo rate), currently at 25.75%, and the borrowing rate (passive rate), currently at 23.75%. The Lebac auctions will continue in 2017, to regulate liquidity, but on a monthly basis after January.

 

BRAZIL – BCB setting the stage for a long easing cycle

There was no monetary policy decision in Brazil in December. The highlight was the 4Q Inflation Report (QIR) published by the Brazilian central bank’s Monetary Policy Committee (Copom), which presented forecasts that set the stage for a long easing cyle, one that may well take the base rate back towards single digits (which we think will happen in early 2018).

Of the four scenarios that the Copom presented, inflation forecasts for 2017 are slightly below the target in those that envisage a static base rate, and above target in those that embed a lower Selic rate. Importantly, forecasts for 2018, that will become increasingly central in the Copom’s policy discussions, are at or below target in all scenarios, even those that incorporate lower rates (specifically, the Selic at 10.5% by end 2017 and 10% by end 2018). That is the key message of the report: a prolonged cycle of easing is not inconsistent with achieving the inflation target.

It should be noted that the forecasts did not incorporate the recent favorable surprise in the December mid-month inflation preview, which led us to trim our forecast for 2016 inflation to 6.3%, from 6.5%. This lower starting point should lead, all other factors staying the same, to lower inflation forecasts in the BCB model, at least for the near term. Said surprise included a favorable development in service price inflation, something that  had been bothering the authorities.  Better behaved forecasts, a more subdued outlook for economic activity, and more encouraging short-term inflation developments should lead the Copom to accelerate to a faster pace of easing from January, 50bps.

There is much debate amongst analysts on the appropriate pace of easing, with some arguing that the Copom should move fast in 2016H1, with two or three 75bps move, and then revert to a slower pace, with a view to providing extra support to economic activity in a time of need. Another approach, which seems to be preferred by the authorities, is to proceed at a slower pace, 50bps, to insure against a still unsettled external environment, and, especially, to make sure that this time the movement to a lower-rate environment is permanent – which would ultimately be more supportive of economic activity.

Our call remains that the Copom will cut its base rate by 375bps in 2017, starting with 50bps in the January policy meeting. The call for 2018 stands at 8.50%, but that is more uncertain, as we reckon that there is a good chance, and it would be the perfectly right thing to do, that the government will lower the inflation target for 2019 to 4%, with short-term implications for the menu of policy options.

 

CHILE – Gradual easing ahead

As widely expected, the central bank of Chile left its monetary policy rate unchanged, at 3.5%, in the final monthly meeting of 2016. This completed a full year on hold after the implementation of a short tightening cycle in 4Q15. The decision followed disappointing October activity and the consolidation of inflation at a low level. In this context, the central bank adopted an easing bias for the first time after four months of holding a neutral tone. Furthermore, the minutes of the meeting reveal that one board member already voted for a 25-bp rate cut.

Following the meeting, the central bank also signaled easing in its 4Q16 Inflation Report. Specifically, the central bank assumed a policy rate trajectory close to that derived from various interest rate expectation measures (trader and analyst surveys, as well as asset prices), which at that time inferred an easing cycle of 50-bps. The baseline scenario is based on a more benign outlook for inflation, meanwhile growth forecasts now consider the recovery towards potential occurring at a slower pace.

We expect the central bank to cut the policy rate to 3.25% in January, with the second rate cut also coming in 1Q17. With downside risks to activity remaining and inflation set to hover around 2% for a meaningful part of 2017, we believe further monetary easing will come later in the year. We see the policy rate ending 2017 at 2.5%.

 

COLOMBIA – Unexpected rate cut

At its December meeting, the board of the central bank of Colombia implemented the first cut in what we anticipate to be an extended loosening cycle. The 25-bp move comes earlier than envisioned by us and the market, as we believed the central bank would opt for the uncertainty over the tax reform and the outcome of the minimum wage negotiations to be resolved before reducing the reference rate. The decision was by a majority for the second consecutive month. The board moved from a 5-2 breakdown in favor of holding the rate in November to a 4-3 majority for a rate cut.

The minutes of the meeting show that the majority of the board think that the policy rate is high compared with historical standards and with the neutral rate. With improving inflation expectations and diminishing demand-side pressures, a rate cut was deemed appropriate by this group. Those who dissented still believe there is insufficient evidence to confirm inflation’s speed of convergence to the target range.The minority of the board flagged the indexation mechanisms in place in the economy, wage growth and the possible exchange-rate impacts from policy changes abroad that could jeopardize the targeted disinflation process.

With inflation set to continue to moderate in December and activity indicators remaining weak, we expect the central bank to cut the policy rate by a further 25 bps in January, to 7.25%. In a context of falling inflation and lower external imbalances, we think the central bank will continue to bring the policy rate closer to more neutral levels. We expect the policy rate at 6.0% by the end of 2017, but we see downside risks for this forecast in spite of the more challenging external environment (which includes the possibility of a tighter monetary policy stance in the U.S.) and the possibility of second-round effects from the tax hikes.

 

MEXICO – A hawkish surprise once again

Mexico’s central bank raised the policy rate by 50 bps (from 5.25% to 5.75%), surprising the market (and our own forecast), which had expected a 25-bp hike. The hike was likely a reaction to the hawkish tweak in the U.S. Fed’s monetary policy guidance (that is, higher “dots”). Banxico had been stressing that the interest rate differential with the U.S. is a crucial variable to monitor, and the Fed’s decision the previous day to hike by 25 bps was accompanied by an upward adjustment in the interest rate path projected by Fed governors. In fact, the statement of Banxico’s decision highlights that U.S. fiscal policy could be "very expansionary" in 2017 and that the Fed will tighten monetary policy at a "faster-than-expected pace," according to the latest communications.

The minutes of the meeting also reveal concerns over other shocks affecting consumer prices. The board believes that the inflation outlook has deteriorated further. Some board members argued that the simultaneous occurrence of temporary shocks on inflation (peso depreciation, gasoline price liberalization, minimum wage hikes and possible agricultural price increases) could have second-round effects on inflation expectations. Unlike in the previous minutes, the board now highlights the magnitude and persistence of the increase in breakeven inflation. Furthermore, one board member stated that the inflation outlook by itself (regardless of what the U.S. Fed does) justifies the tightening of Mexico’s monetary policy.

We expect Banxico to deliver two 25-bp hikes in 2017 (up to 6.25%), assuming the Fed makes similar moves. In our view, Mexico’s interest rates will be highly contingent on the path of U.S. monetary policy. Nevertheless, considering the deterioration of the inflation outlook and the upside potential for the Fed fund rate, Banxico could raise interest rates by more than we currently expect.

 

PERU – Central Bank cuts reserve requirements for foreign currency

The Central Bank (BCRP) announced that reserve requirements will be cut in January 2017, in an attempt to cushion the rise of U.S. Treasury yields in Peru’s partially dollarized financial system. The foreign currency marginal reserve requirement will be cut significantly, from 70% to 48%, bringing the mean reserve requirement rate (weighted average of minimum and marginal rates) down to 25% in January (from 36% in December 2016), according to our estimates. In contrast, the domestic currency reserve requirement – whose minimum rate is equal to the marginal rate – will be barely lowered, from 6.5% to 6.0%.

The success of the de-dollarization strategy implemented since 2015 has provided the BCRP with degrees of freedom to lower foreign-currency reserve requirements. Historically, the BCRP has set higher reserve requirements for foreign currency as a de-dollarization policy, with the aim of discouraging financial intermediation denominated in U.S. dollars (vis-à-vis Soles). Nevertheless, the share of USD-denominated banking credit has decreased from 43% in December 2014 to 32% in November 2016. So now the Central Bank has more room to cut reserve requirements, and thus support credit growth (mainly for corporates and foreign trade, which need USD funding).   

We do not believe that the lowering of reserves requirements marks the beginning of an easing cycle, and we still expect the BCRP to maintain the policy rate at 4.25% throughout 2017. Granted, this move signals that the BCRP is more concerned about the weakness of domestic demand, but a rate cut in the short run is still unlikely. At least until December 2016, the monthly monetary policy statement still expressed an explicit tightening bias. Moreover, headline inflation ended 2016 above the target range, for a third consecutive year. We also note that there were signs of stress in local currency liquidity in December 2016, so the lowering of domestic currency reserve requirements could just be an instrumental policy to normalize those conditions.

 

4. Calendar of monetary policy decisions in January



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