Itaú BBA - Copom Minutes: slightly uncomfortable

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Copom Minutes: slightly uncomfortable

December 12, 2017

The minutes outline a flight path for the Selic on its way to 6.75% by February, while the March decision is left open.

The minutes from the Central Bank’s Monetary Policy Committee (Copom) December meeting confirmed the message, presented in the statement, that the base case for now is a 25bps cut in February, provided current economic conditions, namely recovery of economic activity amidst wide slack, especially in the labour market, remain unchanged. The committee signals that it may be somewhat uncomfortable with the pace of convergence (from below, for a change) of inflation towards the target and stresses the importance of progress on the reforms and adjustments front in order to limit inflation risks and consolidate the environment for lower interest rates. All in all, we stick to the view that the Copom will cut the Selic rate to 6.50 in March 2018, in what will be the end of the current easing cycle. 
 

Recent economic developments and the baseline scenario

The batch of economic data released since the last policy meeting in October remains consistent with gradual recovery of economic activity. The economy is still working with ample slack, as shown by capacity utilization indices and, specially, the unemployment rate.

The external environment remains favorable, with a gradual economic recovery that has not exerted excessive pressure on financial conditions in advanced economies. This has contributed to support appetite for risk assets in emerging markets. 

Inflation is deemed to have behaved to a large extent (new qualification) as expected. Price dynamics have remained favorable, with several core measures at comfortable or low levels (previously just comfortable), including in components more sensitive to the economic cycle and monetary policy. This is a first hint that inflation may be a tad lower than what is envisaged in its expected convergence path towards the target. 

The text then outlines the Copom’s key assumptions and forecasts. Within the former, the note cites the expectations for regulated prices, 8.0% (up from 7.9%) for 2017, and 4.9% (down from 5.1%) for 2018, and 4.2% (previously 4.3%) for 2019. Its inflation forecasts under market interest rate and exchange rate assumptions stood at 2.9% for 2017, and 4.2% (down from 4.3%) for 2018, with the base rate at 7.0% pa in year-end 2017 and in 2018, rising to 8.0% during 2019, evidencing modest changes of the forward looking scenario.

Risks

The Copom envisages downward and upward risks to the basic inflation scenario. The downward risks stem from potential second-round effects of the favorable food price shock and of currently low industrial price inflation, as well as from the propagation, through inertial mechanisms, of the currently low inflation levels. On the upside, the risks come from possible frustration of expectations on the needed (fiscal) adjustments and reforms that may affect risk premia and inflation within the relevant policy horizon, and from a reversal of the currently benign external environment. 

The committee notes that the economy faces favorable and unfavorable price shocks. The former relate to falling food prices, while the latter are due to rising energy costs. And the authorities signal that they will fight second-round effects of said shocks, in a symmetric way. 

Policy discussion

The text notes, in paragraph 12, that available evidence confirms the gradual recovery of economic activity. The committee also notes that there are signs of a recovery in employment even at the current stage of the cycle (something that has also puzzled analysts outside the central bank). Copom members note that the economic juncture has led to increases of 2018 GDP growth forecasts. The authorities repeat that, with the currently (wide) level of slack, these short-term fluctuations are unlikely to lead to material shifts in prospective inflation. 

Paragraph 13 repeats the assessment that the external environment is favorable, with a gradual recovery, that has failed to exert excessive pressure on financial conditions. Members noted that while global financial conditions have become somewhat less expansionary, as yet the impact on emerging economies has been limited. 

In paragraph 15 the Copom sketches the arguments to explain this year´s inflation target undershoot, mostly attributed to falling food prices, that much more than offset rising administered prices (related to rising electricity tariffs). 

Paragraphs 17 and 19 hint that the authorities may be a bit uncomfortable with the pace of reflation, admitting to an internal debate on whether the path of core inflation measures is consistent with convergence of inflation to the target in the relevant policy horizon – of course, if that is deemed not to be the case, then there may be grounds for corrective policy action. 

The key messages in the text, in paragraphs 23-25, indicate that the authorities are weighing, in their deliberations, the apparently sedate pace of convergence of inflation to the target, set against the risk that the frustration of reform expectations, may impact the current inflation juncture (particularly in an scenario of reversal of the benign external environment). Such frustration would materialize, we expect, in a combination of effects on inflation, inflation expectations, and asset prices. 

Policy decision

The Committee states that, considering the basic scenario and balance of risks, a 50bps rate cut is consistent with inflation convergence to the target in the relevant policy horizon. In paragraph 30, the committee notes again that the economic juncture warrants sub-structural (or neutral) interest rates. Looking forward, in paragraph 32 the Copom indicates that, under the basic scenario, and taking into account the issues cited above, a moderate reduction of the pace of easing in the next policy meeting (to 25bps) seems, at the moment, adequate, but adds that the outlook is more uncertain than in previous meetings.

Interpretation

The minutes outline a flight path for the Selic on its way to 6.75% by February. The March decision is left open. Even in the case of a frustration of expectations of reform, we believe the authorities may consider, given the magnitude of estimated economic slack, the balance of risks around the basic scenario, and the slow pace of convergence towards the target, that a little more stimulus may be appropriate. We thus keep, for now, our call that the end will only come in March, with a final 25bps rate cut, taking the Selic to 6.5%pa.


 



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