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COPOM Minutes: on hold, but divided

February 11, 2020

The text points to unchanged interest rates for the time being – we expect the Selic rate to end the year at the present 4.25%.

• The Copom meeting minutes indicate that the authorities are firmly on hold, at least for the time being, but also suggest that the committee members may be divided on the key issue of the magnitude of the output gap. Paragraphs 10 and 11 raise the issue that sluggish manufacturing activity and investment, even while the labor market recovers, might be a sign of emerging supply-side constraints. This does not seem to be the consensus view within the committee, but given that the Copom has not mentioned supply constraints for a number of years, this part of the text may dominate market reaction, at least initially.  The text also addresses, in paragraph 15, the risks posed by the coronavirus outbreak, which may impact activity negatively, but also exert pressure on asset prices (read, further weaken the BRL), with offsetting effects on future inflation. 

• In all, the text points to unchanged interest rates for the time being – we expect the Selic to end the year at the present 4.25%. However, if the supply-side constraint view becomes dominant within the committee, with monetary stimulus still in the pipeline, then the next policy move would be up, rather than further down, although this may take several quarters to materialize.

Recent economic developments and the baseline scenario

Regarding economic activity, the Copom states that data released since its latest meeting indicate continuity of the gradual recovery in the Brazilian economy.

In its assessment of the external scenario, the committee considered that, despite the recent increase in uncertainty, the accommodative stance of monetary policy in major economies still produces a relatively favorable environment for emerging economies.

The Copom assesses that several underlying inflation measures are at levels compatible with the inflation target in the relevant horizon for monetary policy (as opposed to “comfortable levels” in the previous minutes).

The minutes then describe the committee’s main assumptions and forecasts. In the hybrid 1 scenario, with constant exchange rate at BRL 4.25/USD and interest rates extracted from the Focus survey, the inflation forecast is close to 3.5% for 2020 (from 3.7% in the previous Quarterly Inflation Report - QIR) and 3.7% for 2021 (same level from the previous QIR). This scenario assumes interest rates trajectories that end 2020 at 4.25% p.a. and increase up to 6.00% p.a. by 2021. In this scenario, regulated price inflation forecasts are at 3.7% for 2020 (from 3.9% previously) and 4.1% for 2021 (from 4.0%).

In the scenario with constant interest rate at 4.50% p.a. and exchange rate constant at BRL 4.25/USD, inflation is forecast at 3.5% for 2020 (from 3.6% in the latest QIR) and 3.8% for 2021 (from 3.7%). In this scenario, regulated price inflation forecasts are at 3.7% for 2020 (from 3.9% in the previous QIR) and 4.1% for 2021 (from 4.0%).

As in the statement, the committee did not publish its forecasts for the market scenario (with trajectories for interest and exchange rates extracted from the Focus survey), which were at 3.5% for 2020 and 3.4% for 2021 in the previous QIR. 

Risks

Regarding the balance of risks for inflation, the Copom continued to highlight that, in its baseline scenario, risk factors in both directions remain. On the one hand, the high level of economic slack may continue to produce an inflation path below expectations. On the other hand, the current degree of monetary stimulus, which acts with lags on the economy, may increase the trajectory of inflation above expectations in the relevant horizon to monetary policy. The Copom continued to assess that this risk intensifies in the event of a deterioration of the external scenario for emerging economies or an eventual frustration with the continuity of the necessary reforms and adjustments in the economy, and also highlighted, as in the post-meeting statement, the risk stemming from the increase in the power of monetary policy resulting from changes in financial intermediation and in credit and capital markets. 

Policy discussion

In paragraph 10, the Copom discussed the evolution of economic activity and assessed that the data released since its previous meeting indicate that there is a dichotomy between the evolution of the labor market and the growth in the production of goods and services. While the labor market continues to recover gradually, industrial production and recent investment indicators performed below expectations.

In this context, paragraph 11 reveals that Copom members reflected on the level of slack in the economy. Some members assessed that there may be supply constraints, possibly resulting from the exhaustion of the centralized model of capital allocation and the long period of recession, so this dichotomy in recent data suggests the possibility that economic slack is smaller than that measured by traditional methods. In paragraph 12, however, the division in the committee becomes clear, as other members stressed that the dynamics of the core inflation signals that the economic slack is still high.

In addressing the financial conditions in paragraph 13, the committee members concluded that they are at favorable levels, despite the inherent volatility in such measures. This benign environment results, according to the authorities, from the expansion of the degree of monetary stimulus, the relatively favorable external environment for emerging economies and the expectation of improvement in the fundamentals of the Brazilian economy.

Paragraph 14 mentions that the committee discussed the characteristics of the current cycle, where there is less state participation in the economy, and its implications for monetary policy. Some committee members pointed out that changes in the credit market and financial intermediation, with a greater role for non-earmarked credit and capital markets, will likely (instead of “may”, as in the previous minutes) impact the effectiveness of monetary policy and, due to the lack of historical comparisons, tend to increase uncertainty about its transmission channels. The text once again mentions that the Copom members believe that credit and capital market developments tend to increase the power of monetary policy.

Regarding the international environment, in paragraph 15 the committee assesses that the scenario remains relatively favorable for emerging economies. The paragraph also reveals the committee's discussion of the effects of coronavirus on the global economy. The Copom's view is that the eventual extension or intensification of the outbreak would imply a further slowdown in global growth, with impacts on commodity prices and important financial assets. The committee concludes that the consequences of such event on monetary policy will depend on the relative magnitude of the global economic slowdown versus the reaction of financial assets (read exchange rate).

In paragraph 16, the Copom discusses its recent inflation forecasts. In the relevant horizon for monetary policy, the scenario with Selic rate extracted from the Focus survey and constant exchange rate produces inflation below (no longer “slightly below”, as in the previous minutes) the target for 2020 and around the target for 2021. The committee points out that short-term forecasts were particularly affected by the effects of the protein price shock, which, after being stronger than expected at the end of 2019, show partial reversal at the beginning of the year. Regarding regulated prices, the Copom mentions that conditions remain favorable for the occurrence of minor readjustments in electricity tariffs.

Paragraph 17 shows the Copom understands that the scenario with anchored inflation expectations, underlying inflation measures compatible with the target, inflation forecasts below or around the target for the relevant monetary policy horizon and a high degree of slack in the economy prescribe stimulative monetary policy (that is, interest rates below the structural rate).

That said, paragraph 18 shows that, in view of the multiple uncertainties regarding the current degree of slack, the speed of the economy's recovery and the increase in the power of monetary policy, which operates with lags, the Copom considers that it is important to observe the effects of the monetary stimulus cycle started in 2019. The Committee believes that it is essential to understand these effects to define the next steps of the monetary policy.

This last argument is reinforced in paragraph 19, in which the committee, after mentioning that the protein price shock anticipated inflation to 2019 from 2020, again reinforces that, due to the uncertainties about the lag and the magnitude of the effects of the stimulus already provided, it is essential to observe the evolution of economic activity and inflation forecasts and expectations over the next few months, with an increasing weight for 2021.

Policy decision

Considering the baseline scenario, the balance of risks for inflation and the current available information, the Copom decided to cut the Selic rate by 25 bps, to 4.25% p.a., and stated that it would be warranted to interrupt the easing cycle, taking into account the lagged effects of recent interest rate cuts, and also that the current stage of the economic cycle prescribes caution in monetary policy decisions. As usual, the authorities reaffirmed that their next steps will continue to depend on the evolution of economic activity, the balance of risks and the inflation expectations and inflation forecasts (with increasing importance being placed on the 2021 estimates).

Interpretation

The Copom meeting minutes indicate that the authorities are firmly on hold, at least for the time being, but also suggest that the committee members may be divided on the key issue of the magnitude of the output gap. Paragraphs 10 and 11 raise the issue that sluggish manufacturing activity and investment, even while the labor market recovers, might be a sign of emerging supply-side constraints. This does not seem to be the consensus view within the committee, but given that the Copom has not mentioned supply constraints for a number of years, this part of the text may dominate market reaction, at least initially.  The text also addresses, in paragraph 15, the risks posed by the coronavirus outbreak, which may impact activity negatively, but also exert pressure on asset prices (read, further weaken the BRL), with offsetting effects on future inflation. 

In all, the text points to unchanged interest rates for the time being – we expect the Selic to end the year at the present 4.25%. However, if the supply-side constraint view becomes dominant within the committee, with monetary stimulus still in the pipeline, then the next policy move would be up, rather than further down, although this may take several quarters to materialize.


 



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