Itaú BBA - Copom Cockpit: End of the cycle

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Copom Cockpit: End of the cycle

May 10, 2018

We believe that the Copom will follow the path presented in the March meeting and announce a final 25bp-reduction in the Selic in May.

The Brazilian Central Bank’s Monetary Policy Committee (Copom) meets again next week. Recent data continue to show an environment of low inflation and anchored expectations, amid a more gradual recovery in activity and weaker-than-expected economic activity figures in 1Q18. Copom's inflation forecasts will likely increase for 2018 and remain stable for 2019 compared to those published in March in the minutes of the last committee meeting and in the most recent Inflation Report.
 

We expect the Copom to announce a final 25-bp cut in the Selic rate after the May 15-16 meeting, seeking to minimize risks of inflation converging later to the target.  Since the March meeting, we saw relevant changes in the scenario, but with ambiguous signs for monetary policy. On one hand, activity figures – namely industrial production, the monthly service survey and labor market data – disappointed this year, possibly favoring another cut. On the other hand, recent exchange rate fluctuations and the FX outlook reduce the risks of inflation converging later to the target — and that could decrease the need for more easing.

In recent communications, committee members pointed to two aspects of recent economic developments: (1) there were no significant changes in the balance of risks for inflation; and (2) FX policy is independent from monetary policy, so that the recently-announced net offering of swap contracts does not represent a change in plans for monetary policy. Thus, we believe that the Copom will follow the path presented in the March meeting and announce a final 25-bp cut in the Selic in May.

1 – Recent data 

Recent data on inflation, measured by the IPCA, continued to print below expectations since the last Copom meeting, pointing to a scenario of contained inflationary pressures, with a good composition. In April, the mid-month IPCA-15 advanced 0.21%, below market consensus (0.25%), with the year-over-year rate remaining stable at 2.80%. The IPCA went up 0.22% in April, also below expectations (0.28%), and the year-over-year increase picked up to 2.76% (2.68% in March), but remains at historically-low levels. The average of three core measures of the IPCA (smoothed trimmed means, double weight core and core inflation by exclusion) rose 0.18% in April (0.19% in the previous month), while the year-over-year rate declined to 3.0% (from 3.1%). Importantly, the high degree of economic slack —particularly the unemployment rate remaining above the level that usually fuels wage pressures — contributes to keep several underlying inflation measures at low levels, including components that are more sensitive to monetary policy.

Economic activity continues to show a recovery trend, although at a slower pace. There were disappointing figures at the margin, especially in industrial production, the monthly service survey and labor market data. Industrial production dropped 0.1% mom/sa in March, missing market expectations (+0.5%). The gross reading for February was revised downward by 0.4 p.p., worsening the negative impact on forecasts for the 1Q18 GDP report.   The breakdown analysis outlines a mixed picture. Among economic categories, there were seasonally-adjusted monthly gains in the production of durable consumer goods (1.0%), capital goods (2.1%), and other consumer goods (0.2%), while production of intermediate goods dropped 0.7%.

According to the Monthly Service Survey (PMS, by census bureau IBGE), real revenues from services increased 0.1% mom/sa in February, after a 1.9% drop in the previous month. The year-over-year change fell 2.2%, a much lower reading than the median of market estimates (-0.6%). Breaking down the indicator, 4 out of 5 sub-sectors tracked by the survey posted declines. Importantly, the PMS encompasses just 34% of services GDP and does not represent the sector fully. 

Core retail sales fell 0.2% mom/sa in February, also missing the median of market expectations (0.7%). Compared to February 2017, core sales expanded 1.2%. In our view, the seasonally-adjusted quarterly change provides a good indicator of the recent dynamics in retail sales. Using this metric, core sales were stable in February, while broad retail sales advanced 0.7%. The positive reading suggests that household spending continued to expand in 1Q18.

In March, 56,200 formal jobs were created, according to the Ministry of Labor. Adjusting for seasonality, only 27,300 positions were opened, dragging the quarterly moving average down to 27,000 from 38,000. Given that the December-March period is ruled by sharp and unstable seasonality, the next reports will be key to assess whether the weakening pace of formal job creation (as per the quarterly moving average) is just noise (our take) or flags an interruption in the gradual improvement in formal employment. In terms of unemployment, according to the national household survey (PNAD Contínua), the unemployment rate climbed to 13.1% in the quarter ended in March (above the expectation of 12.9% rate) from 12.6% in the quarter ended in February, driven mostly by monthly seasonality. The many labor market indicators (PNAD, CAGED, DIEESE/SEADE) for the period show a slowdown in employment and real wages, affecting the outlook for household spending this year and reinforcing the downside to GDP growth in 2018. 

In the fiscal side, the consolidated public sector posted a primary budget deficit of 25.1 billion reais in March, close to market expectations (-24.5 billion). The consolidated primary deficit accumulated over 12 months deteriorated to 1.6% of GDP from 1.4% in February. The central government’s result, as published by the National Treasury, was a deficit of 24.8 billion reais, affected by discretionary expenses increasing after several months at low levels and by 10 billion reais in payments related to so-called precatório debt bonds that were anticipated, after taking place in May last year. Regional governments posted a surplus of 0.6 billion reais, while state-owned companies had a deficit of 0.2 billion reais. Despite the weak readings, meeting primary targets in 2018 should be less challenging than in recent years. The general government’s gross debt reached 75.3% of GDP in March (75.1% in February). Although the primary result is still negative, the upward trend in public debt is set to moderate, reflecting the cyclical rebound in economic activity, historically-low interest rates and development bank BNDES repayments to the National Treasury.

 

2 – Inflation forecasts

Copom's inflation forecasts will likely increase for 2018 and remain stable for 2019 compared to those published in March in the minutes of the last committee meeting and in the most recent Inflation Report.

Since the publication of the 1Q18 Inflation Report (the lastest communication piece featuring the BCB’s forecasts), inflation expectations collected by the Focus survey receded to 3.49% for 2018 (from 3.63%), and 4.03% for 2019 (from 4.20%). For 2020, inflation expectations remained at 4.00%, in line with the target set by the National Monetary Council (CMN).

Expectations for the Selic rate declined to 6.25% for 2018 (from 6.50%), remaining stable at 8.00% for 2019 and 2020. As for the exchange rate, expectations moved to 3.37 reais per dollar in 2018 (from 3.30) and 3.40 in 2019 (from 3.39 in the last Inflation Report). For 2020, the median of expectations for the exchange rate stands at 3.47 reais per dollar (3.46 in the last Inflation Report).

The table below summarizes the estimates based on our model, which attempts to replicate the BCB’s small-scale model. We estimate that the inflation forecasts presented to the Copom will rise to 4.0% in 2018 (3.8% previously) and remain stable at 4.1% in 2019.

 

3 – Communication changes and the Copom-o-Meter

In the post-meeting statement and minutes of the last monetary policy meeting, the committee signaled that the evolution of the basic scenario warranted a 25-bp cut in the benchmark rate and, at that moment, considered appropriate moderate additional easing in May, seeking to minimize risks of inflation converging later to the target. Policymakers emphasized that this assessment could change if it became clear that the risks of later convergence to the inflation target had receded, so that the monetary easing cycle could stop as early as in May. For meetings after May — i.e. from June onward —, the Copom signaled that, with the economy evolving as expected, interrupting rate cuts would be appropriate. 

In the minutes of its last meeting, the committee regarded the external scenario as favorable, with economic activity continuing to recover globally and helping to sustain — until that moment —  appetite for emerging market assets. In recent communications, given the strengthening dollar around the world, Copom members acknowledged changes in the external situation and are evaluating these risks, at a time when the Brazilian economy still requires reforms. In such context, if the current upward trend in public debt is sustained, the consistency of the rebound in economic activity and sustainability of historically-low interest rates will be in jeopardy. When asked during an interview about the impact of the rising dollar on inflation, BCB Governor Ilan Goldfajn said that it depends on factors such as economic activity and anchoring of inflation expectations.

In terms of economic activity, the committee signaled that recent evidence shows consistent recovery and that, as the economy rebounds, inflation tends to move gradually toward the target. Despite disappointing activity figures in 1Q18, committee members suggested that the growth trend continues.

They also pointed out that inflation behavior was more benign than anticipated early in the year, with several underlying metrics remaining at low levels, including those components that are more sensitive to the economic cycle and to monetary policy. As for inflation expectations, they remain anchored, with breathing room vs. the targets for 2018 and 2019.

Additionally, in recent communications, committee members pointed to two aspects of recent economic developments: (1) there were no significant changes in the balance of risks for inflation; and (2) FX policy is independent from monetary policy, so that the recently-announced net offering of swap contracts does not represent a change in plans for monetary policy. Thus, we believe that the Copom will follow the path presented in the March meeting and announce a final 25-bp reduction in the Selic in May.

We use our “Copom-o-Meter”, a proprietary index that measures the level of implicit policy expansion or contraction in BCB statements, in an attempt to predict the Copom’s decisions based on its communication. Applying the methodology, we understand that the tone and its evolution are consistent with cut of 25 bps in the benchmark rate after the May meeting.

4 – Our view 

Since the March meeting, we saw relevant changes in the scenario, but with ambiguous signs for monetary policy. On one hand, activity figures – namely industrial production, the monthly service survey and labor market data – disappointed this year, amid restrained inflation dynamics, possibly favoring another cut. On the other hand, recent exchange rate fluctuations and the FX outlook reduce the risks of inflation converging later to the target — and that could decrease the need for more easing.

Having said that, an additional 25-bp cut in the Selic seems compatible with recent comments by committee members conveying that, as set by the inflation targeting regime, inflation expectations, economic activity and the secondary effects of relative prices are the key drivers of inflation in the relevant horizon for monetary policy and, thus, for benchmark rate decisions. Considering that recent exchange rate depreciation did not change medium-term inflation expectations, along with somewhat weaker activity indicators and restrained inflationary dynamics at the margin, we expect the Copom to announce a final 25-bp cut after the May 15-16 meeting, thus ending the easing cycle with the Selic at 6.25%.



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