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Copom minutes: Stable rate in the baseline scenario

May 22, 2018

In our baseline scenario, the Selic rate will remain stable at 6.5% until year-end.

In the minutes released today, the Brazilian Central Bank’s Monetary Policy Committee (Copom) signaled that it would be adequate to maintain the benchmark Selic interest rate unchanged at 6.5% p.a. in upcoming meetings, given the current balance of risks and inflation forecasts at comfortable levels. The Copom pointed out that recent FX depreciation will pass on to inflation to an extent that depends on many factors, such as the degree of slack in the economy and how anchored inflation expectations are. Hence, the next decisions will contemplate the behavior of many measures of FX pass-through, allowing an assessment of the intensity of the impact of exchange rate fluctuations on price levels and whether there is need to implement monetary policy actions meant to fight their secondary effects. In our baseline scenario, the Selic rate will remain stable at 6.5% until year-end, but the monetary policy stance will still depend on FX dynamics and, in special, its impact on inflation readings and inflation expectations, particularly for 2019.
 

Recent economic developments and the baseline scenario

According to the Copom, the latest indicators outline a slowdown, in an environment of consistent, albeit gradual, recovery in economic activity. The economy continues to run with high levels of slack in production factors, reflecting low industrial capacity utilization and, especially, unemployment.

The external environment is now regarded as challenging, as the evolution of risks associated with interest rate normalization in some advanced economies led to adjustments in financial markets and sparked volatility. Consequently, risk appetite for emerging market economies decreased.

The Copom understands that inflation continues to behave favorably, with several underlying inflation measures remaining at low levels, including those components that are more sensitive to the economic cycle and monetary policy. 

The text then outlines the Copom’s key assumptions and forecasts. Considering interest rate and exchange rate expectations reported in the Focus survey, the committee’s estimates for inflation hover around 3.6% for 2018 and 3.9% for 2019 (vs. 3.8% and 4.1% in the previous meeting). In this scenario, the exchange rate would reach 3.40 reais per U.S. dollar by YE18 and YE19, with inflation in regulated prices at 5.7% and 4.2%, respectively (vs. 4.8% and 3.8% previously).

The committee also presented a scenario in which the exchange rate is constant at 3.60 and the benchmark interest rate at 6.50% – maybe more relevant in light of recent FX moves –, in which its inflation forecasts shift to 4.0% for 2018 and 2019 (with regulated prices rising 6.3% and 4.4%, respectively).

Risks

The Copom continues to envisage downward and upward risks to the basic inflation scenario. The main downward risk to inflation is currently low levels of inflation possibly spreading through inertial mechanisms. 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. This risk would intensify if the reversal of the global scenario for emerging economies — no longer described as favorable — continues. In fact, the Copom stated that the latter risk increased since its last meeting.

Policy discussion

Paragraph 11 notes that committee members agree that the pace of economic activity slowed down at the margin (in the previous meeting, only one member mentioned a slight slowdown). Nevertheless, the Copom still sees signs of consistent recovery, but now describes it as gradual. 

On paragraph 12, the evaluation of the external scenario is no longer favorable, and the committee stressed that it became more challenging. This is caused, in particular, by the risk of a faster pickup in interest rates in some advanced economies, leading to asset price adjustments and greater volatility in international markets. Geopolitical risks were also mentioned, along with risks that could impact international trade, with possible impacts on global growth. In this context, the committee again highlighted the Brazilian economy`s capacity to absorb external setbacks given its robust balance of payments, low inflation, anchored inflation expectations, and the outlook for economic recovery. Furthermore, the Copom argued that, if the evolution in the external scenario leads to changes in relative prices (i.e., the exchange rate), the impact on monetary policy would be restricted to its secondary effects on inflation — a recurring point throughout the text.  

On paragraphs 13 and 14, the committee discussed the inflation scenario and concludes that the situation remains favorable, with underlying inflation measures still at low levels. With more intense risks that the reversal of the external scenario will continue, the Copom understands that the risk of postponed inflation convergence to its targets decreased. In particular, the Central Bank`s conditional forecasts produce inflation levels seen as comfortable by the Copom. And, given the current balance of risks, the committee sees lower chances of inflation printing below target in the relevant horizon for monetary policy.

Paragraphs 15 and 16 discuss the potential effect of the exchange rate on monetary policy. With anchored expectations, only secondary effects should be addressed by the Copom. Furthermore, the committee stressed that its reaction would be symmetrical in the face of inflationary and deflationary shocks. Having said that, the committee discussed the degree of FX pass-through to the Brazilian economy and, given its many drivers (for instance, economic slack and how anchored expectations are), it decided to monitor different measures for inflation and underlying inflation. 

About discussions that took place during the meeting, paragraphs 20 and 21 showed that the choice of cutting the benchmark rate by 25 bps was contemplated, given low levels of inflation and underlying inflation, as well as the economic recovery and its recent cooling. The change in the balance of risks for inflation due to the external shock weighed in favor of the option to keep the Selic unchanged at 6.50% p.a. Additionally, members put forth that Copom communication was apparently interpreted by the market as a sign of additional reduction, but the view that the best decision would be to maintain the Selic prevailed, given information available at that moment. 

On paragraphs 22-24, the committee stressed that it is key to understand that monetary policy will not react automatically or mechanically to the evolution of the exchange rate, but rather will focus exclusively on the behavior of inflation forecasts and expectations, the balance of risks, and economic activity. 

The committee also decided to signal, on paragraph 25, that with comfortable inflation forecasts and the current balance of risks, it believes it is adequate to maintain the benchmark rate at the current level in upcoming meetings. 

Policy decision

On paragraph 32, the committee indicated that the evolution of the baseline scenario and, especially the balance of risks, eliminated the need for further easing to mitigate the risk of postponed inflation convergence to its targets. Additionally, the Copom thinks that maintaining the benchmark rate at the current level in upcoming meetings is adequate, stressing that the next steps in monetary policy will continue to depend on the evolution of economic activity, the balance of risks and inflation forecasts and expectations.

Interpretation

In the minutes published today, the committee signaled that it would be adequate to maintain the Selic stable at 6.5% in upcoming meetings, given the current balance of risks and inflation forecasts that the monetary authority regards as comfortable. Furthermore, the Copom noted that the extent of pass-through of recent FX depreciation depends on many factors, such as economic slack and how anchored inflation expectations are. Thus, the behavior of different measures of FX pass-through will weigh on upcoming decisions, as they will allow an assessment of the impact of FX fluctuations on price levels and whether monetary policy actions are needed to fight its secondary effects. In our baseline scenario, the Selic rate will remain stable at 6.5% until year-end, but the monetary policy stance will still depend on FX dynamics and, in special, its impact on inflation readings and inflation expectations, particularly for 2019.



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