Itaú BBA - Inflation Report: inflation forecasts reinforce a scenario of stable Selic rate

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Inflation Report: inflation forecasts reinforce a scenario of stable Selic rate

June 28, 2018

Brazil´s Central Bank models point to inflation below or close to target in all scenarios for 2018, 2019 and 2020.

The inflation report shows inflation forecasts around 4.2% for 2018 and 4.1% for 2019 and 2020 in the scenario with constant interest rate at 6.50% pa and constant exchange rate at BRL 3.70, against targets of 4.5%, 4.25% and 4.0%, respectively. In the market scenario, which considers interest rate and exchange rate forecasts in line with BCB’s Focus survey, which currently assumes a 6.50% Selic rate by the end of 2018, rising to 8.0% in 2019, the inflation forecasts are 4.2% for 2018 and 3.7% for 2019 and 2020. This scenario features an exchange rate at BRL 3.63 by YE2018 and 3.60 by YE2019 and regulated prices that rise 7.2% in 2018, 4.6% in 2019 and 3.8% in 2020. Inflation forecasts for 2019 (below the target in the market scenario and close to the target in the reference scenario) are consistent with the maintenance of the Selic rate at the current level. In the hybrid scenario that assumes constant exchange rates and interest rates in line with market expectations, inflation forecasts are around 4.2% for 2018, 3.9% for 2019 and 3.7% for 2020. Finally, in the hybrid scenario that assumes exchange rates in line with market expectations and constant interest rates, forecasts point to 4.2% inflation in 2018, 3.8% in 2019 and 4.1% in 2020.

As shown in the table, inflation forecasts are below or near the target in all scenarios for 2018, 2019 and 2020. According to the central bank, anchored inflation expectations, fading effects of the BRL depreciation and the economic recovery trend contribute to around-target inflation forecasts for 2019 and 2020. In this sense, the BCB  indicates that the stimulative monetary policy favors the reduction of spare capacity and contributes to the convergence of inflation to the target.

As usual, the IR includes scenario revisions and some interesting studies in its boxes. As a matter of fact, BCB’s 2018 GDP growth forecast was significantly reduced, to 1.6% from 2.6%, incorporating the weaker activity at the beginning of the year, softer confidence indicators and the direct and indirect effects of the trucker’s stoppage.

In terms of studies, the box "Private components of aggregate demand in cycles of economic recovery" analyzes the patterns of recent cycles and concludes that the private sector’s recovery pace in the current cycle is similar to that of 1999 and 2001, but falls short of the 2003 and 2009 cycles. Going back to a theme explored in previous IRs, the BCB presents in the study "Broad corporate funding” an indicator of overall funding conditions for the private sector, based on data gathered at the firm level. In a similar way to the previous studies, it concludes that the large companies’ funding through capital markets and external debt issuances were more than enough to offset BNDES’s retreat, causing broad financing for larger companies to grow 3.1% since the end of 2016. However, this trend is not confirmed in the case of smaller firms. Since they typically have less access to capital markets, this group of companies underwent a steep deleveraging process, as both their non-earmarked and ear-marked credit operations were sharply reduced.

Today's IR also brought interesting boxes on the BCB’s inflation modeling. The box "New core inflation measures," introduces metrics that expand the concept used for the underlying services indicator to food products (keeping only the least volatile items) and industrial goods – excluding ethanol (because of the volatility that stems from of supply fluctuations) and cigarettes, vehicles and electronic appliances (because these prices are very affected by tax-related issues). The new core index “IPCA-EX2” adds the new indicators of food and industrial goods to underlying services inflation, while the IPCA-EX3 aggregates only services and industry. According to the study, the new core measures show greater adherence to the output gap and appear to include the inflation components that are more sensitive to the economic cycle. Finally the box "Small disaggregated model", presents estimated coefficients for the exchange rate pass-through on industrial products, food items and BCB’s EX0 core measure (which excludes food consumed at home and regulated prices). Food inflation is the one with the greatest and fastest reaction to the exchange rate: the effects of a permanent 10% depreciation are concentrated in the first two quarters and reach their maximum in four quarters, with a 2.2 pp increase in 12-month inflation. Industrial goods have a lower response level, peaking at 0.9 pp in four quarters. The  pass-through is even lower in the case of EX0 (due to the presence of service prices, which react less to the exchange rate): the cumulative change reaches 0.4 pp after four quarters.

In sum, the central bank's inflation forecasts and the revised 2018 GDP growth estimates released in June’s Inflation Report point to a relatively comfortable scenario for inflation. In fact, in all four scenarios shown by the BCB, inflation forecasts are below or near the target by the end of 2019 and 2020. In scenarios that contemplate the market expectations for interest rate, inflation projections tend to be below the target in both 2019 and 2020, which indicates that the Selic’s path shown in the Focus survey (8.0% at the end of 2019 and 2020) contemplates rate hikes that, at this moment, do not seem to be necessary, according to BCB’s models. We maintain our call that the Selic rate will remain at 6.50% until at least the end of this year.



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