Itaú BBA - How much can 2017 inflation expectations fall?

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How much can 2017 inflation expectations fall?

julio 15, 2016

In our view, inflation expectations for 2017 may fall 40-50 bps until the release of the next Inflation Report

The central bank has been reaffirming its commitment to bring annual inflation down to the 4.5% target by the end of 2017, i.e. one and a half years from now. 

We designed a measure of inflation expectations for this timeframe (18 months ahead) and concluded that its evolution depends on inflationary inertia, on the labor market gap, on well-anchored inflation expectations and on forecasts of the exchange rate path. 

In our view, inflation expectations for 2017 may fall 40-50 bps until the release of the next Inflation Report (in September 2016) if the exchange rate stabilizes around 3.25 reais per U.S. dollar and longer-term inflation expectations (2018 and 2019) move to the target.

The role of inflation expectations and their recent path

In its 2Q16 Inflation Report, published in late June, the central bank stated that, given current conditions, there is no room for reducing interest rates. The monetary authority emphasized that progress in the fight against inflation depends on the approval and implementation of adjustments, particularly on the fiscal front. If approved, fiscal measures will probably have a positive impact on country risk spreads and the exchange rate and, thus, on inflation expectations.

In fact, inflation expectations have been falling in the past few months (Table 1 and Chart 1)[1]. For the end of 2016, the average market expectation dropped to 7.3% in early July from 7.6% in March. The slide was even sharper for longer time frames: the average forecasts dropped to 5.4% for 2017 (from 6.1% in March) and to 4.9% for 2018 (from 5.6%). Nevertheless, the central bank conditioned near term monetary easing on the need for further reductions in inflation expectations.

In order to assess possible declines in inflation expectations in the coming months, we built an historical series of expected inflation for the next 18 months[2] (Chart 2). We focused on the time horizon of one year and a half, which by now means the end of 2017. This time frame is important because recent central bank communication reaffirmed its commitment to bring inflation to the 4.5% target in 2017.

Main drivers of inflation expectations 18 months ahead:

We regressed inflation expectations 18 months ahead into four drivers:

  1. A measure for the labor market gap[3]
  2. Inflationary inertia
  3. Inflation expectations three years ahead as a proxy for the inflation rate that economists believe is actually targeted by the central bank[4]
  4. Expected change in the exchange rate one year ahead[5]

Table 2 shows that this regression has strong explanatory power.

An increase of 1 pp on year-over-year inflation lifts inflation expectations by 0.15 pp. The same hike in the expected inflation target increases expectations by 0.9 pp.

Meanwhile, if market agents forecast 10% exchange rate appreciation one year ahead, inflation expectations fall by 0.25 pp. 

What is the likely behavior of 18-month inflation expectations in the coming months?

Improvements in expectations in the coming months rely on two factors:

  1. Stronger anchoring of inflation expectations, so that the rate that economists perceive as the central bank’s actual target (inflation expectations three years ahead) falls to 4.5% from 4.8% currently.
  2. A stronger expected BRL one year from now, which depend on the current exchange rate (Table 3 in the Appendix).

Assuming that:

  1. Inflation expectations three years ahead will converge to 4.5% due to the monetary authority’s recent communication about its commitment to drive inflation to the target.
  2. Market agents will come to expect a stronger currency (at the 3.25[6] level) in their forecasts.

The fall in inflation expectations may total 40-50 bps in the next three months (Chart 3).

Importantly, improvements of 40-50 bps in 18-month inflation expectations within only three months are historically rare (Chart 4). Such movements occurred only in periods of abrupt reversal of economic activity (2008/2009 crisis) and when the government signaled greater intention of fiscal adjustment and spending cuts (early 2015 and more recently). 


 

Julia Gottlieb



[1] Throughout this report, we use the average of inflation expectations and not the median (used more often). The choice for the average is due to smoother moves than those seen for the median.

[2] Expected inflation 18 months ahead is a simple average between inflation expectations 12 and 24 months ahead. Expectations 12 months ahead are published by the central bank. In order to calculate expected inflation 24 months ahead, we weighted by the number of days past in the year, inflation expectations by the end of the next year and by the end of two years forward.

For instance, inflation expected within 24 months at a given moment in 2016 will be the weighted average between inflation expectations for the end of 2017 (the weight is the number of days past in 2016) and the end of 2018 (weight is the number of days to go before 2016 ends). Hence, by the last day of 2016, the total weight will be attributed to expectations for the end of 2018.

[3] Deviations from the historical average in the FGV indicator of survey respondents who report that it is difficult to find a job.

[4] We believe that inflation expectations three years ahead reflect the view of economists (who fill out the Focus survey) about the inflation target pursued by the central bank.

[5] Based on information provided by Focus, as in the case of inflation expectations.

[6] We forecast the exchange rate at 3.25 reais per dollar by the end of 2016.


 



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