Itaú BBA - Inflation report: inflation forecasts support an additional 25-bp rate cut in May
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Inflation report: inflation forecasts support an additional 25-bp rate cut in May

March 29, 2018

We expect the Selic rate to be cut to 6.25% in May, remaining at this level until at least the end of the year.

The BCB’s inflation report shows inflation forecasts at 3.8% in 2018 and 4.1% in 2019 in the active scenario, with interest and exchange rates forecasts in line with market expectations (according to the Focus report), which currently assumes Selic rate stable at 6.50% until the end of 2018, rising to 8.0% in 2019. The inflation forecasts below targets (4.5% for 2018 and 4.25% for 2019) reinforce the BCB’s recent communication, maintained in today’s report, that the base-case for now is one more 25-bp cut in May, taking the Selic rate to 6.25%. In the hybrid scenario, with a constant exchange rate and interest rates following market expectations, inflation forecasts are lower, at 3.6% for 2018 and 3.9% in 2019.

Given the forecasts and the central bank’s communication we stick to the view that the Copom will cut the Selic by another 25bps to 6.25% in May. The Copom believes this additional cut mitigates the risk of a slower-than-anticipated convergence of inflation to the target. But the authorities also highlight that this assessment can change if it becomes clear that this mitigation of risks is no longer required, leading to the interruption of the easing cycle already in May. For meetings after the next one, that is, from June onwards, the Copom states that, with the economy evolving as expected, it would be proper to interrupt the monetary easing process.

As shown in the table below, inflation forecasts are below center-target in all the scenarios for both 2018 (4.5%) and 2019 (4.25%). For 2020, inflation forecasts are close to the 4.0% target in all scenarios, except for the one that considers that Selic rate will remain stable and the exchange rate will follow market expectations. In this scenario, inflation is forecasted at an above-target 4.4% in 2020.

As customary, the IR includes a couple interesting boxes. There is a study about the effect of monetary cycles on the credit market, in which the BCB concludes that monetary policy is being effective in stimulating new loans and reducing the cost of credit – just about as much as it has been in previous easing cycles. Breaking credit down by segment, the BCB observes that lending for households has picked up much faster than that for corporates, a fact that is further explored in the next box, which finds that the drop – and the subsequent muted recovery – of corporate credit is being at least partially offset by the fact that capital markets and external debt issuances have become significantly more active last year. For companies that raised funds through one of these sources, broad indebtedness rose about 18% in 2017, while debt with the financial system fell by almost 11%. In another box, the BCB looks into the money withdrawals from inactive FGTS accounts, which provided a one-off boost for the budgets of about 26 million individuals. The study shows that Brazilians used most of this extra money to reduce debt or make down payments for real-estate loans (about 40% each). A little less than 20% was used for consumption and around 3% for clearing up delayed debt payments. Finally, there is quite an interesting study that tries to fit the exchange-rate forecasts of Brazilian institutions using three theoretical models. It finds that for most institutions in the sample, the uncovered interest rate parity model is the one that performs the worse in explaining the forecasts. The random walk model does the best job in explaining short-term forecasts, while for between 2-11 month ahead, the purchasing power parity is the model that best explains analysts’ forecasts. For longer terms, purchasing power parity and random walk do not significantly outperform one another.

In summary, the IR released today shows that the BCB’s inflation forecasts indicate there is room for the Selic rate to be cut a bit further, in line with the recent communication indicating another 25bps cut in May to 6.25%. We stick to the view that 6.25% pa should be the resting place of the Selic at the end of this cycle – and we expect the rate to be cut to said level at the Copom meeting in May, remaining there until at least the end of the year.

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