Itaú BBA - Copom Cockpit: 100-bp cut amid uncertainties

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Copom Cockpit: 100-bp cut amid uncertainties

May 26, 2017

We now expect the Copom to deliver a 100-bp cut, thus maintaining the pace of the previous meeting.

The Brazilian Central Bank's Monetary Policy Committee (Copom) will meet again next week. Recent data pictures environment of low inflation and anchored expectations, with activity showing signs of weakness on the margin. The Copom's inflation forecasts are expected to drop slightly for 2017 and 2018. 

However, with the significant rise in uncertainty regarding the approval of reforms, we now expect the Copom to deliver a 100-bp cut, thus maintaining the pace of the previous meeting, compared to previous expectations of a sharper cut. It should be noted that the committee's decision is subject to new political developments, which affect asset prices and the prospective trajectory of inflation. In particular, if new events, up to the meeting day, worsen the chances of approval of the reforms and increase risk premiums on Brazilian assets, a moderate reduction in the easing pace should not be ruled out, although this is not our baseline scenario.

In its communiqué, we expect the Copom to indicate that the extent and pace of the monetary easing cycle will depend on inflation forecasts and expectations and on the risk factors associated with the scenario - including non-economic factors. Thus, the Copom will probably keep all options open for the next monetary policy movements at the present time of high uncertainty. 

The terminal Selic rate level will crucially depend on how current political conditions will evolve and the impact on the probability of approval of the economic reforms. In a more adverse political scenario that leads to a prolonged postponement of reforms, the easing cycle could be shortened, but the Selic rate would still drop to a single digit. Give this context, we revised our forecast for the yearend interest rate from 7.5% to 8.0%.

1 – Recent data

Inflation data remain below expectations, with a widespread decline among the components. In particular, services inflation, an item of special interest to the monetary authorities, maintained the recent pace of decline, reflecting the strong deterioration of the labor market. In terms of wholesale prices, there was deflation in April, given the drop in agricultural commodity prices.

Economic activity deteriorated again, after showing more strength in the beginning of the year. Industrial production contracted in March, well below expectations. It is worth noting that this result has little impact on the scenario of positive GDP growth in the first quarter of 2017, but leads to a negative statistical carryover for the following quarter. The first coincident indicators point to stagnation of industrial production in April. In the labor market, job creation was positive in April, above expectations. However, seasonally adjusted, 34,000 formal jobs were lost, a level still consistent with an increase in the unemployment rate. Finally, activity in the service sector and retail sales also fell short of expectations.

On the fiscal side, sequential results remain negative, reinforcing the need for approval of reforms. Since the most recent Copom meeting, the Social Security reform’s base text was approved by the Lower House Special Committee. The proposal will then be submitted to a vote in the Lower House floor, which will likely be delayed due to the substantial increase in uncertainty arising from recent political events.

2 – Inflation forecasts 

The Copom's inflation forecasts, considering Focus survey’s[1] interest rates and exchange rates, will likely be lower than those reported at the April meeting, as inflation expectations continued to recede.

Since the April meeting, inflation expectations dropped to 3.9% from 4.1% in 2017, and to 4.3% from 4.5% in 2018. In addition, Selic rate epectations stood flat at 8.5% (for 2017 and 2018). As for the exchange rate, expectation for the end of 2017 remained at 3.23 reais per dollar, while there was a slight decline to 3.36 reais per dollar in 2018 (compared to 3.37 reais per dollar at the April meeting).

The table below summarizes the estimates based on our model, which attempts to replicate the BCB’s small-scale model. According to our calculations, we estimate that the inflation forecasts presented to Copom declined to 3.9% from 4.1% in 2017 and to 4.4% from 4.5% in 2018.

3 – Communication changes and the Copom-o-Meter

Given higher uncertainty arising from recent political events, an assessment of the BCB's communication should contemplate different points in time.

At first, the minutes of the Copom meeting in April brought back an asymmetric signaling to the next monetarypolicy movements, which had been removed from the meeting's communication. An important section of the minutes stated that "the economic developments would already allow a faster pace of monetary easing"than what was decided at themeeting, but the committee eventually opted for a "moderate" acceleration given the forward-looking nature of monetary policy and the uncertainty around the scenario. The Copom also indicated that it considers "the current pace adequate", however, in view of the economic developments, it recommended "monitoring the evolution of the determinants of the degree of front-loading of the cycle".

In recent communications at the beginning of the second half of May, the authorities indicated that "uncertainties have increased due to information arising from the political environment", and that the "BCB is monitoring the impact of this information and working to maintain the full functionality of the markets". But it highlighted that "despite this non-economic factor, Brazil has robust buffers and is therefore less vulnerable to internal or external shocks". In addition, it communicated that "there is no direct and mechanical relationship" between the central bank's management and monitoring of the effects of recent shocks and monetary policy, and that the latter "will continue to be defined by the Copom at its regular meetings, with a focus on its traditional goals".

In trying to anticipate the Copom's decisions based on the BCB's communication, we use the Copom-o-meter, an index that measures the level of implicit policy contraction or easing in BCB's communication. Applying the methodology, we understand thatthe tone of the adopted communication is consistent with the continuity of the pace delivered at the latest monetary policy meeting. Thus, the Copom-o-meter reinforces the scenario of maintenance of the 100-bp easing pace at the meeting next week.

4 – Our view

The increase in uncertainty due to recent political events represents a potentially recessive and inflationary shock to the Brazilian economy. The potential negative impact of the shock on economic activity will come from a subsequent increase in caution of economic agents. On the other hand, the potential inflationary impact of the shock will only be significant if there is a sharper and persistent depreciation of the exchange rate than has been the case until now. Given the still uncertain effect of the current shock, the baseline scenario still contemplates weak economic activity and disinflation. This scenario justifies maintaining the monetary easing cycle.

The current environment of high political uncertainty, however, suggests caution on the BCB’s side. More specifically, further acceleration of the easing pace would not be prudent given the current scenario. It should be noted that, even before the recent events, the Copom's communication left the doors open to intensify or maintain the easing pace. The increase in political uncertainty tends to consolidate the more cautious option, i.e. maintaining the current easing pace.

In short, we expect the Copom to deliver a 100-bp rate cut at next week's meeting, thus maintaining the pace of the previous meeting. Obviously, the committee's decision is subject to new political developments. In particular, if new events, up to the meeting day, worsen the chances of reforms’ approval and increase risk premiums on Brazilian assets, a moderate reduction in the pace of easing should not be ruled out, although this is not our baseline scenario.

In its communiqué, we expect the Copom to indicate that the extent and pace of the monetary easing cycle will depend on inflation forecasts and expectations and on the risk factors associated with the scenario - including non-economic factors. Thus, the Copom will probably keep all options open for the next monetary policy movements at the present time of high uncertainty. Looking ahead, however, we believe that the risk of a slowdown in the monetary easing cycle outweighs the risk of further acceleration.

The terminal Selic rate level will crucially depend on how current political conditions will evolve and the impact on the probability of approval of the economic reforms. In a benign scenario where the reforms are slightly postponed, the easing cycle will likely near the 7.5% level that we were forecasting before the rise in uncertainty. If, however, a more adverse political scenario materializes, leading to a prolonged postponement of reforms, the easing cycle could be shortened, but with the Selic rate still falling to a single digit. In this context, in an environment of uncertainty above the usual level, we revised our forecast for the yearend interest rate from 7.5% to 8.0%.



[1] The Copom stated in the February minutes that, in the context of the ongoing monetary easing process, forecasts with constant interest rates are not very informative and it will only disclose in its meetings' statements and communications the conditional inflation forecasts in scenarios that it considers informative of its view on the conduction of monetary policy.


 



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