Itaú BBA - What to expect for the 4Q17 Inflation Report

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What to expect for the 4Q17 Inflation Report

December 18, 2017

In the market scenario, we anticipate inflation at 2.8% for 2017 and 4.2% for 2018 and 2019.

This Thursday, the Brazilian Central Bank’s Monetary Policy Committee (Copom) will release the last Inflation Report (IR) of 2017. We believe that, following the recent line of communication, the monetary authority will signal a path to the Selic rate towards 6.75% in February, as long as current economic conditions remain unchanged. Even if reform expectations are thwarted, we believe that policymakers may consider that a little more stimulus may be appropriate, given the magnitude of estimated excess capacity, the balance of risks around the baseline scenario and the slow pace of convergence towards the target. Thus, we maintain for the moment our view that the end of the cycle will only come in March, with a final cut of 25 bps, leading to a Selic rate of 6.5%.
 

In the market scenario, we anticipate 2.8% for 2017 and 4.2% for 2018 and 2019. In hybrid scenario 1, with the Selic moving in line with the Focus survey and a constant exchange rate, we calculate that the Central Bank will forecast inflation at 2.8% for 2017, 4.2% for 2018 and 3.9% for 2019. In hybrid scenario 2, with a constant Selic rate and the exchange rate in line with market expectations, the Central Bank’s inflation estimates should be 2.8% for 2017, 4.1% for 2018 and 4.4% for 2019. Finally, in the reference scenario, with constant Selic and exchange rates, expected inflation forecasts are 2.8% for 2017 and 4.1% for 2018 and 2019. 

The Copom releases on Thursday the 4Q17 Inflation Report (IR). The table below summarizes our attempt to replicate the results of the Central Bank’s forecast model, as per the market scenario (Selic and exchange rates in line with the Focus survey), hybrid scenario 1 (Selic in line with the Focus survey and constant exchange rate), hybrid scenario 2 (constant Selic rate and exchange rate in line with Focus) and the reference scenario (constant Selic and exchange rates). Our cutoff date is December 14. 

Importantly, as we approach the end of the easing cycle (as signaled by the Copom), inflation forecasts that assume a constant Selic rate (hybrid scenario 2 and reference scenario) become more informative and should be closely monitored. Starting with the 2Q17 Inflation Report, the Central Bank attributed less importance to the reference scenario, regarding its content as less informative than the other inflation scenarios, due to the ongoing monetary easing process. In such context, in the next IR, the possible decision to publish again the reference scenario may be another indication that the end of the easing cycle is near. 

In the market scenario, forecasts in the Focus survey for the exchange rate stand at 3.25 reais per U.S. dollar for 2017, 3.30 for 2018 and 3.38 for 2019. The surveyed estimates for the Selic are 7.0% for 2017 and 2018 and 8.0% for 2019. We expect the 2017 inflation estimate to recede to 2.8%, from 2.9% in the December meeting. For 2018 and 2019, we anticipate 4.2%, in line with the December meeting. 

In hybrid scenario 1, we see the inflation forecast at 2.8% for 2017 vs. 3.2% in the last quarterly inflation report. For 2018, we anticipate 4.2% vs. 4.1% in the 3Q17 IR. For 2019, we estimate 3.9%, in line with the 3Q17 IR. In hybrid scenario 2, we forecast inflation at 2.8% vs. 3.2% in the last IR. For 2018, we expect the forecast to be unchanged from the previous IR, at 4.1%. For 2019, our call is 4.4% vs. 4.0% in the 3Q17 IR.

In the text, we do not expect any message that is materially different from recent communications laid out by monetary authorities. Following the recent line of communication by the committee, the baseline scenario is a 25-bp cut in February, as long as economic conditions evolve as expected – i.e., a recovery in economic activity amid wide slack, particularly in the labor market.

The set of economic data published since the last IR remains consistent with a gradual recovery in economic activity. As for inflation, according to the minutes of the Copom meeting in December, price dynamics remained favorable, with several core measures at low or comfortable levels, including components that are more sensitive to the economic cycle and to monetary policy. 

Also in the minutes of the last meeting, the committee signaled that it may be somewhat uncomfortable with the pace of inflation convergence to its target (now approaching it from below). On the other hand, it reinforced the need for reforms and adjustments to limit risks for inflation and consolidate the conditions for lower interest rates.

The Copom stated that, considering the baseline scenario and the balance of risks, a 50 bp-cut is consistent with inflation convergence to its target in the relevant horizon for monetary policy. It also pointed out that the economic situation requires interest rates below the structural (neutral) level. Going forward, the committee signaled that, in the baseline scenario and considering matters mentioned above, a moderate reduction in the pace of monetary easing in the next monetary policy meeting (to 25 bps) seems adequate at the moment, but added that the outlook is less certain than in previous meetings.

In our view, as signaled by the minutes of the last Copom meeting, Central Bank communications suggest that the Selic will be reduced to 6.75% in February. The March decision remains open. Even if expectations for reforms are frustrated, we believe that policymakers may consider, given the magnitude of estimated idleness, the balance of risks around the baseline scenario and the slow pace of convergence towards the target, that a little more stimulus may be appropriate. Thus, we maintain for the moment our view that the end of the cycle will only come in March, with a final cut of 25 bps, leading to a Selic rate of 6.5%.



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