Itaú BBA - Falling inflation brings forward the cycle of interest rate cuts

Brazil Scenario Review

< Volver

Falling inflation brings forward the cycle of interest rate cuts

enero 20, 2017

The central bank has increased the pace of interest rate cuts. We forecast the Selic rate at 9.75% in 2017 and 8.5% in 2018.

Please open the attached pdf to read the full report and forecasts.

• Economic activity in Brazil was disappointing in the final stretch of the year, but the demand fundamentals remain stable. We have lowered our estimate of 2017 growth to 1% (from 1.5%) because of the statistical carryover, but we maintain our forecast of 4% growth for 2018.

• We expect Social Security reforms to be approved in the second quarter of 2017.

• We have revised our year-end exchange rate forecasts to BRL 3.50 per dollar for both 2017 and 2018. 

• Inflation continues to fall. We now expect the IPCA to be 4.7% in 2017 and 4.0% in 2018.

• The central bank has increased the pace of interest rate cuts. We are forecasting Selic rates of 9.75% in 2017 and 8.5% in 2018.

Lower growth and interest rates this year

Economic activity in Brazil was disappointing in the final stretch of the year. This has translated to a worse statistical inheritance for 2017. However, the demand fundamentals remain stable at the margin. The inventory cycle, improving commodity prices and monetary policy loosening should allow for moderate growth this year (1%), but we are not likely to see a more robust recovery until 2018 (4%).

In 2017, the spotlight will remain on fiscal reforms. The Lower House of Congress will likely approve the proposed Social Security reforms, which are critical for achieving future compliance with the spending cap, by the end of the second quarter.

With a slightly more favorable external scenario for emerging-market countries, we now expect less intense BRL depreciation. We are now forecasting year-end exchange rates of BRL 3.50 to the dollar for both 2017 and 2018.

Inflation ended 2016 lower than expected and will likely continue to fall over the months ahead. The composition of the Extended National Consumer Price Index (IPCA) remains benign, with various components retreating, including service prices. We have lowered our IPCA inflation forecasts to 4.7% from 4.8% for this year and to 4.0% from 4.2% for 2018.

Falling inflation has created an opportunity to front‑load the monetary easing cycle. At its January meeting, the central bank reduced the Selic benchmark rate of interest by 0.75 percentage points (pp). We are forecasting two additional cuts of this magnitude at the February and April meetings. The Selic rate is likely to reach 9.75% by the end of 2017 and 8.5% by the end of 2018.

We have lowered our 2017 GDP forecast to 1.0%

Industrial activity data have been disappointing recently. In November we saw a tepid 0.2% rise in industrial output, after a 1.2% decline in October. This was a disappointing outcome relative to our forecasts and market expectations. Although preliminary indicators are pointing to an increase in December, this is unlikely to offset the previous month’s letdown.

According to the Monthly Services Survey (PMS‑IBGE), real service sector revenues remained essentially stable (0.1%) in November, after a significant 2.3% drop in October. Retail sales surprised positively in November, but initial indicators suggest that they dropped back sharply in December. In our opinion, this pattern occurred because people made their year-end purchases earlier (a Black Fridayeffect that has not yet been satisfactorily captured by seasonal adjustment algorithms).

Business confidence fell in December. Over the final month of the year, confidence fell in three of the four main sectors of economic activity. Industrial inventories worsened at the margin. Demand remained stable and above installed capacity utilization (Nuci), but excessive inventories were back on the rise. The inventory adjustment cycle is therefore likely to last a little longer than expected, in which case industrial output will rise more slowly. However, given our previous observations of the automotive sector, we expect to see inventories stop fallingin the months ahead, which would support an economic recovery.

GDP likely to fall again in 4Q16. Industrial output was not the only disappointment in 4Q16, as other sectors also failed to perform as expected. We estimate that GDP will fall by 0.6% in the fourth quarter of 2016 compared with the preceding quarter, after seasonal adjustment (we had previously forecast that GDP would remain stable). All else being equal, the statistical inheritance for 2017 would then deteriorate to -0.8% from -0.4%. Despite weaker data at the margin, however, demand fundamentals remain stable. More specifically, commodity prices (which, on average, are likely to rise in 2017 compared with 2016) and ongoing monetary policy easing may support moderate growth in 2017. We have therefore lowered our 2017 GDP forecast to 1.0% (from 1.5%), incorporating the less favorable statistical carryover. This change in GDP at the margin is likely to extend throughout 2018, allowing for 4.0% growth next year.

Negative surprise from the formal labor market. In November, a net of 117,000 formal jobs were destroyed (according to figures from CAGED). Stripping out seasonal effects, we estimate a contraction of 128,000 jobs (spread fairly evenly across all sectors). We expect job destruction to ease in the coming months as the downturn in economic activity attenuates.

Unemployment remains high. The national unemployment rate rose to 11.9% in November. With seasonal effects stripped out, unemployment registered its 24th consecutive monthly increase, climbing to 12.3% from 12.1%. As economic activity is growing more slowly than we expected, we are now forecasting an unemployment rate of 13.2% for the end of 2017, up from 12.2% previously. In 2018 we expect a small drop in unemployment, to 12.9%, given the lag in the job market’s reaction to economic activity.

Fiscal: spotlight remains on reforms in 2017

Throughout 2017, the spotlight will remain on the approval and implementation of fiscal reforms. 

This will be the first year that the new public spending cap is in effect.In December of last year, the Senate approved and the President sanctioned a constitutional amendment limiting primary federal expenditure growth to the previous year’s inflation rate for the next ten years. The amendment will reverse the 20-year trend of uninterrupted real increases in primary federal expenditure, gradually correcting the fiscal imbalance as the economy returns to growth.[1] 

The Lower House will debate Social Security reforms – which will be critical for future compliance with the spending cap – during the first half of this year. Social Security expenditure represented 40% of the federal government’s total primary expenditure (8.0% of GDP) in 2016 and is poised to increase in real terms over the coming years as the population ages. The proposed reform would better align the federal budget with Brazil’s demographic trends, setting a minimum retirement age of 65 and unifying the rules on access to Social Security benefits for men and women, public-sector and private-sector workers, and urban and rural residents.[2]  

In the Brazilian states that are in the most precarious financial situations, such as Rio de Janeiro, Rio Grande do Sul and Minas Gerais, fiscal reform will be addressed through a fiscal recovery regime. Under the regime, the states will have a grace period of up to three years on debt repayments to the federal government. In exchange, their legislative assemblies will have to approve adjustments to control spending and increase revenues, in order to correct their structural imbalances.[3]  

We believe that the fiscal reforms and progress on state-level adjustments are critical for stabilizing Brazil’s medium-term public debt. We forecast a return to primary surpluses only in 2020, but a return to growth and a structural decline in interest rates following the adoption of reforms could slow the pace of annual public debt growth significantly. More specifically, we believe that public debt will remain stable at around 80% of GDP from 2018 on.

We have raised our forecast for the 2016 primary deficit to 2.6% of GDP (BRL 160 billion) from 2.4% of GDP (BRL 150 billion). We revised our estimateto incorporate a BRL 5 billion increase in payments from previous fiscal years (“restos a pagar”) in December of last year and a BRL 5 billion transfer to municipal governments linked to fines levied under the foreign asset repatriation program, which we had not previously included in this account. With this, the primary result is now likely to be only slightly ahead of the annual target of -2.6% of GDP (BRL -164 billion).

We have maintained our forecast for a primary deficit of 2.2% of GDP (BRL 142 billion) in 2017, in line with the government target. We have included the BRL 10 billion raised under the new tax regularization program, which is likely to offset an equivalent revenue shortfall resulting from our worsening growth forecasts. Meeting the year’s primary result target will mean realizing BRL 60 billion in extraordinary revenues, which we expect to come from the tax regularization program, an extension of the asset repatriation program, energy auctions, infrastructure concessions and taxes raised from IPOs.

For 2018, we expect a primary deficit of 1.6% of GDP (BRL 116 billion). This forecast takes into account the second year of the spending cap and BRL 35 billion (0.5% of GDP) in extraordinary revenues, which is compatible with a gradual reversal of Brazil’s fiscal imbalance.

Less intense BRL depreciation

The exchange rate ended 2016 at BRL 3.25 to the dollar. The external environment has become more favorable for emerging-market economies, with rising commodity prices and a drop in risk aversion (which had risen because of the U.S. elections in November), which helps explain why the USD has lost strength against other currencies, including the BRL.

We have lowered our exchange-rate forecasts to 3.50 BRL per dollar at the end of 2017 (previously 3.60) and 3.50 BRL per dollar at the end of 2018 (previously 3.70). We are forecasting a slightly more favorable external scenario for emerging-market economies than we had previously. Even so, as U.S. interest rates increase (however gradually) throughout the year and commodity prices drop from their current levels, the BRL is likely to depreciate from current levels. Our scenario assumes the approval of the Social Security reforms. This currency trend is in line with a scenario of a slight increase in current account deficits, at levels that will not compromise external sustainability.

In 2016, the trade surplus reached USD 48 billion,[4] the highest level in the historical series (since 1992). Exports fell slightly from 2015 levels (USD 185 billion in 2016, compared with USD 191 billion in 2015), but a sharp decline in imports (to USD 138 billion from USD 171 billion) on the back of weak activity guaranteed a largely positive outcome. Despite the trade surplus, we again saw a significant reduction in Brazil’s trade flow, which fell to USD 323 billion from USD 363 billion.

The current account deficit continued to retreat in 2016. The 12-month current account deficit shrank to 1.1% of GDP in November, compared with 3.3% at the end of 2015. The improvement was widespread, driven by successive trade surpluses and lower service and income deficits. However, the current account deficit stabilized at the margin. The annualized three-month moving average, with seasonal effects stripped out, has been hovering around a USD 20-25 billion deficit since September of last year.

On the financing side, direct investment in the country amounted to 4.4% of GDP, enough to fully cover the current account deficit and thus reducing dependency on more volatile financing sources. However, foreign investment in portfolios (fixed-income and the stock market) continued to show outflows (1% of GDP over the 12 months through November).

For the coming years, we forecast a slight increase in the current account deficit, but not enough to compromise external sustainability. We forecast trade surpluses of USD 46 billion in 2017 and USD 37 billion in 2018. We forecast a USD 30 billion current account deficit in 2017 (previously USD 29 billion) and USD 43 billion deficit in 2018.

Lower inflation forecasts for 2017 and 2018

The IPCA rose 0.30% in December, slightly below our estimates and median market expectations. As a result, after posting a 10.7% increase in 2015, the index ended last year up just 6.3% – well below what was expected just a few months ago and within the inflation target tolerance range. Market prices rose by 6.6% last year (compared with 8.5% in 2015), contributing 5.0 pp to inflation over that period (down from 6.6 pp in 2015).Regulated prices rose by 5.5% last year (compared with 18.1% in 2015), contributing 1.3 pp to inflation over that period (down from 4.1 pp in 2015).

Our IPCA inflation forecast for 2017 has been lowered to 4.7% from 4.8%. The effects of lower inflationary inertia and the downward revision in our exchange-rate scenario more than offset the impact of unexpected upward pressure on prices in the public transportation and telephony sectors. According to our forecasts, inflation will continue to fall in the months ahead compared with the same period of last year, despite a seasonal first-quarter increase. In the last‑12‑month metric we are forecasting that inflation will fall steadily, to 5.5% in January, 5.1% in March, 4.5% in June and 4.3% in September – and we note that disinflation is likely to trigger a welcome debate about a possible reduction in the inflation target.

On a disaggregated basis, we are forecasting a 4.4% rise in market prices and a 5.6% increase in regulated prices for 2017. Looking at market prices, we have reduced our forecast for home food price inflation to 3.7% from 4.0% (compared with 9.4% in 2016) based on our revised exchange-rate scenario, while maintaining the outlook that the world’s largest agricultural producers will enjoy bumper harvests as they reap the benefit of favorable weather conditions. In the other segments, we are forecasting a 5.3% increase in service prices (compared with 6.5% in 2016) and a 3.4% increase in industrial prices (compared with 4.8% in 2016). The labor market and real estate sector will continue to face adverse conditions; along with a reduced inertial effect from past inflation and smaller increases in the minimum salary, this is likely to have a moderating effect on salary and rent costs, contributing to a further decline in service inflation this year. Looking at regulated prices, we are forecasting price increases of 1% for gasoline, 5% for drugs, 5% for fixed-line telephony, 7% for urban bus transportation, 8% for electricity and 11% for health plans.

Our 2018 inflation forecast has fallen to 4.0% from 4.2%. On a disaggregated basis, we are now forecasting a 3.9% rise in market prices and a 4.5% increase in regulated prices in 2018. The full-year inflation forecast was lowered to reflect the revision of our exchange-rate scenario and the outlook for a slower labor market recovery. As noted above, if there are occasions when inflation comes in below the center of the target range this year, it may create an opportunity to discuss reducing the inflation target for the years ahead.

The main inflation-scenario risk factors are external scenario uncertainties and domestic political issues. Despite the markets’ apparent tranquility at the beginning of the year, greater uncertainty abroad could trigger an increase in risk premiums, which in turn may result in further exchange-rate depreciation. In fiscal terms, any further difficulties moving ahead with the necessary reforms and adjustments could put additional pressure on risk premiums and exchange rates and create an opening for alternative fiscal measures, with a greater focus on tax hikes. So far, however, the signs have been positive for the fiscal reform effort.

The high level of idle capacity in the economy may help to push inflation down further. Although this indicator is subject to uncertainty and errors of measurement, the output gap (the difference between potential GDP and actual GDP) appears to be negative, which could lead to faster market price disinflation over the next few months, particularly in areas that are more sensitive to the economic cycle, like industrial products and services. The inflation surprises in recent months already suggest that there is a more widespread disinflation process underway across exactly these components. This means that progress on fiscal reforms could further improve the outlook for inflation, either through exchange rate and inflation expectations, or via a gradual switch from expansionary to neutral or even contractionary fiscal policies.

More solidly grounded expectations reinforce the scenario of falling inflation. According to the central bank’s Focus survey, median inflation expectations for 2016 retreated again last month, from 4.9% to 4.8%, which is close to the inflation target. In turn, median expectations for 2018 and beyond remain solidly around the target (4.5%), reflecting economic agents’ increasing conviction that the central bank will take steps to ensure that the IPCA will indeed converge over a timeline that will allow monetary policy to have a greater effect.

Monetary policy: lower interest rates in 2017

At its January monetary policy meeting, the central bank decided to make another interest rate cut, this time of 75 bps, bringing the Selic rate to 13.00%, in line with our expectations. In its statement and the meeting minutes, the committee signaled the possibility of at least one more 75-bp cut in February, but did not commit to delivering it. This strategy is justified, in our view, because inflation is falling faster – and more broadly – than expected and activity is failing to meet expectations in an environment where inflation expectations are anchored. The central bank also indicated that this movement is consistent with a front‑loading of the monetary easing cycle but not, in principle, with a change in the total budget for monetary loosening.

In our view, rising unemployment will continue to help bring down inflation, and given no further uncertainty abroad, this should allow the central bank to maintain a faster pace of monetary policy easing over the next several meetings. We expect two additional 75-bp cuts at the February and April meetings.

We have lowered our year-end Selic rate forecast for 2017 to 9.75% (previously 10%), as the inflationary scenario is more benign than we anticipated.

Looking at 2018, we believe that the continued downward trend in inflation and high levels of unemployment are consistent with further interest rate cuts. We expect a Selic rate of 8.50% at the end of 2018.


Please open the attached pdf to read the full report and forecasts.

< Volver