Itaú BBA - Copom Cockpit: one more stimulus

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Copom Cockpit: one more stimulus

March 16, 2018

We expect the Copom to announce a 25-bp cut after its meeting on March 20 and 21

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, in a context of consistent recovery of economic activity, which is becoming increasingly widespread. Copom's inflation forecasts will likely recede for 2018 and 2019 compared to those reported in the last meeting.
 

We expect the Copom to announce a 25-bp cut after its meeting on March 20 and 21. This reduction is compatible with the surprises relative to the BCB’s inflation expectation for 2018 that was disclosed at the most recent monetary policy meeting. We understand that the Copom’s statement and minutes in February signaled the possibility of an additional moderate adjustment if the risk of low inflation intensified, which eventually materialized. In our view, data released since then appear to compose enough of a surprise to lead the Copom to deviate from its original flight plan and add one more stimulus at the next meeting.

While weaker inflation and economic activity data justify this cut, we do not expect the monetary policy rate to fall below 6.5%, as the Copom continues to see convergence of inflation towards the target in 2019 (which is gradually becoming the most relevant horizon for monetary policy). The recovery of economic activity, the lagged effects of monetary policy – which will likely continue to bring additional momentum to the economy – and the balance of risks in the international scenario – which has become less favorable recently due to the outlook of further monetary tightening in the US – also point in this direction. Thus, we see the interruption of the monetary easing process as the most likely scenario, and it is consistent with the Copom’s recent communication.

1 – Recent data 

Recent data on inflation measured by the IPCA continue to point to a scenario of contained inflationary pressures, with a good composition. In January, the IPCA posted a 0.29% advance, below the floor of market expectations. In February, the IPCA inflation rose 0.32%, leading the 12-month-rate to decline to 2.84%, compared to 2.86% in January. Year-to-date, the IPCA in February posted a 0.61% increase, the lowest percentage result for the period since the implementation of Plano Real in 1994, according to IBGE. It is worth noting that the sharp decline in agricultural and food prices in the retail sector last year – due to the favorable supply shock – contributed not only to the IPCA reading (2.9%) below the lower bound of the inflation target range (3.0%) in 2017, but also to keep inflation at low levels in the beginning of 2018, through more favorable inertia. In addition, the high level of slack in the economy, particularly the permanence of the unemployment rate above the level that tends to pressure wages, contributes to the process of more persistent disinflation in market prices, especially those more sensitive to the economic cycle, such as services and industrial goods.

Economic activity continues to show a recovery trend, although still at an uncertain pace. Despite the apparently-weak result at the margin, 4Q17 GDP led to a 1.0% growth in 2017, thus consolidating the economic rebound. Importantly, the weaker seasonally-adjusted GDP expansion in the second half of the year is associated with the strong agricultural harvest being accounted for in the first half of 2017. Consequently, GDP growth at the beginning of 2017 was well above the underlying growth, with the opposite occurring in the second half of the year. More recently, economic activity data at the beginning of 2018 show mixed signs as to the pace of recovery.

There was creation of 77.8 thousand formal jobs in January, according to the Ministry of Labor. Adjusting for seasonality, 46 thousand jobs were created, which led the 3-month moving average to fall from 48 thousand to 46 thousand jobs. It is worth noting that the pace of the past 3 months is already above the necessary to stabilize employment without increasing informality (approximately 40 thousand/month). Meanwhile, the national unemployment rate rose to 12.2% in January from 11.8% in the quarter ended in December. Using our seasonal adjustment, unemployment rose 0.1pp to 12.5%, reflecting a 0.1pp increase in the participation rate (ratio between the economically active population and the working age population). Going forward, we forecast a gradual decline in unemployment, which will be increasingly influenced by the contribution of formal employment.

Industrial production fell by 2.4% mom/sa in January, below the median of expectations. The apparently weak result should be read with a grain of salt, as the recent recession has changed indutry’s composition, reducing the weight of cyclical sectors (which seasonally tend to contract more in December and resume production in January). Thus, the statistical filter that corrects the series by seasonal factors probably adjusted the level of production (upward in December, downward in January) by more than what would be consistent with the new industry composition.

Core retail sales increased by 0.9% in January, while broad retail sales (which include vehicles and construction materials) dropped 0.1% . Given our assessment that the Black Friday is not yet fully incorporated into the seasonal pattern and may distort seasonally-adjusted monthly changes in November and December, the quarter-over-quarter change provides a good indicator of recent retail sales dynamics. In this context, the quarter-over-quarter reading of core retail sales accelerated from 0.0% to 0.4%, while broad retail sales accelerated from 0.5% to 1.2%. As for services, the sector’s seasonally-adjusted real revenue declined 1.9% in January, a negative surprise relative to the median of market expectations. In year-over-year terms, the indicator retreated by 1,3%. The weaker result in the month was widespread across its subcomponents, with 4 of 5 sectors covered by the Monthly Service Survey (PMS) decreasing relative to the previous month. We note that the PMS survey covers about 34% of services GDP and therefore does not represent the entire sector.

On the fiscal side, results continue to improve in the short term. The consolidated public sector posted a primary surplus of R$ 46.9 billion in January, above expectations. Over 12 months, the consolidated primary deficit fell from 1.7% to 1.5% of GDP, indicating that meeting the primary result targets this year will probably be less challenging than in the recent past. In particular, the fiscal results for 2018 will be favored by higher extraordinary revenues, mainly those related to tax recovery programs (Refis), and lower compulsory subsidies. In addition, the dynamics of public debt (especially gross debt) will likely also be a smaller constraint in 2018. Gross general government debt reached 74.5% of GDP and net public sector debt stood at 51.8% of GDP in January. Despite still-negative annual primary results, the return of R$ 130 billion from BNDES to the National Treasury, the acceleration of economic growth and the reduction of real interest rates will keep gross debt relatively stable as a proportion of GDP in 2018. However, in the absence of reforms, such as the pension reform, fiscal results will resume a deterioration trend from 2019 onwards. If the spending ceiling rule is not complied with, the gradual convergence to primary surpluses compatible with the stabilization of public debt will be interrupted, generating concerns about the consistency of the economic recovery and the sustainability of interest rates at historically low levels.

2 – Inflation forecasts
Copom's inflation forecasts, considering market expectations for the interest rates and exchange rates reported by the Focus survey, will likely decline in 2018 and 2019 compared to those indicated at the most recent monetary policy meeting.

Since the February meeting, inflation expectations collected by the Focus survey have declined to 3.67% for 2018 (from 3.94%), and 4.20% for 2019 (from 4.25%). 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 6.50% for 2018 (from 6.75%), remaining stable at 8.00% for 2019 and 2020. As for the exchange rate, expectations remained at 3.30 reais per dollar in 2018 and marginally declined to 3.39 reais per dollar in 2019 (from 3.40 reais in February). For 2020, the median of expectations for the exchange rate stands at 3.46 reais per dollar (3.45 in February).

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 decline to 3.8% in 2018 (4.2% previously) and 4.1% in 2019 (4.2% previously).

 

3 – Communication changes and the Copom-o-Meter
In the statement and the minutes of the most recent monetary policy decision, the committee stated that, considering the baseline scenario and the balance of risks, a 25-bp rate cut was consistent with the convergence of inflation to the target in the relevant monetary policy horizon. The Copom also signaled that the end of the cycle is near, and indicated at that time that an interruption of the easing cycle would be the most appropriate option for the next meeting. However, the authorities pointed out that this view could change if the baseline scenario or the balance of risks were to change. In this context, given the increasing signs that inflation is becoming more entrenched at its currently-low levels, presumably due to new downward surprises, a decision in favor of an additional moderate stimulus is possible.

Copom members have assessed that the external scenario is still considered favorable, noting that labor market conditions in some core economies (namely, the US) have started to raise wages. There is also an outlook that inflation in such economies will converge to the targets. This reinforces the scenario of gradual normalization of monetary policy in mature economies, although the behavior of wages and prices may make this process more volatile and produce some tightening of global financial conditions. On the economic activity side, the committee signaled that the set of economic data shows a consistent recovery in activity, and that as the economy recovers, inflation tends to return to the target.

They also evaluated the behavior of inflation as favorable, with several underlying inflation measures at comfortable or low levels, including components that are more sensitive to the economic cycle and monetary policy. In recent public communication, members of the Copom acknowledged their surprise with the low inflation readings in 2018, reflecting the materialization of the risk indicated in the statement and the minutes, and, in our view, ratifying the addition of stimulus at the March meeting.

In trying to anticipate the Copom's decisions, 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 that the tone of the communication adopted since the latest monetary policy meeting and its evolution are consistent with a 25-bp interest rate reduction after the March meeting.

4 – Our view 
 

We expect the Copom to announce a 0.25pp rate cut after its meeting on March 20 and 21. This reduction is compatible with the inflation surprises relative to the BCB’s expectation for the IPCA inflation in 2018 disclosed at the most recent monetary policy meeting. We understand that the Copom’s statement and minutes in February, albeit pointing to a pause in the easing cycle, signaled the possibility of an additional moderate adjustment if the risk of low inflation intensified. In our view, data released since then appear to compose enough of a surprise to lead the Copom to deviate from its original flight plan and add one more stimulus at the next meeting.

While weaker inflation and economic activity data justify this cut, we do not expect the monetary policy rate to fall below 6.5%, as the Copom continues to see convergence of inflation towards the target in 2019 (which is gradually becoming the most relevant horizon for monetary policy). The recovery of economic activity, the lagged effects of monetary policy – which will likely continue to bring additional momentum to the economy – and the balance of risks in the international scenario – which has become less favorable recently due to the outlook of further monetary tightening in the US – also point in this direction. Thus, we see the interruption of the monetary easing process as the most likely scenario, and it is consistent with the Copom’s recent communication.

 



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