The BC (Central Bank) of Brazil is expected to raise the Selic rate by 50 basis points to 13.75% per year next week. According to the Focus survey, this will be the last increase of the year – an expectation supported by the recent communication from the monetary authority. Some factors, however, indicate that such a decision can be quite risky.
First, the IPCA cores (which exclude the effects of temporary shocks, such as energy and food increases) in the first half of the year were the highest since 2003, the diffusion index is close to its highest level in history, which together with the high inertia of our economy are signs that disinflation tends to be much more gradual than the BC expects.
Second, inflation expectations continue to deteriorate, which constitutes a high risk for current inflation. The difference between the Focus survey’s 2023 inflation expectation and the target is two percentage points (the highest in the series).
Expected inflation for 2024 has already started to rise, something that is not common to happen so far in advance. The implied inflations (difference between nominal and real interest rates) negotiated in the market point to rates between 6.2% and 7% for any negotiated horizon.
Our BC has never before ended a process of monetary tightening with expectations on its horizon of action on the rise.
Third, the idle capacity of the economy has turned out to be smaller than expected. This year’s average GDP growth expectations have risen from 0.3% to 1.9% since January. The BC itself recognizes the strong performance of the activity, especially the job market.
Although financial conditions are restrictive and there are lags in monetary policy, the fact is that, so far, demand has not felt so much.
Fourth, fiscal policy has been more expansionary (with tax cuts and an increase in the value of Auxílio Brasil), offsetting part of the monetary tightening.
At the same time, the weakening of the fiscal framework tends to put pressure on the country’s risk premium, generating exchange rate depreciation, which adds risks to future inflation.
Fifth, we are facing a sharp rise in international interest rates. Global recession fears increase risk aversion and bring a strong dollar environment. A lower interest rate differential, in addition to the drop in commodity prices, leads to a more devalued real and greater inflationary pressure.
The disinflationary impact of the fall in commodities will depend on the behavior of the real. So far, the drop in commodities in reais is not a factor of great relief for inflation.
In addition to all these reasons, the current level of inflation should itself be a major factor for greater caution, as it influences the probability of inflation perpetuating itself over a longer horizon.
In its latest annual report, the BIS (Bank of International Settlements) brings just such a discussion.
High inflation regimes induce significant behavioral changes. Workers and companies try to compensate for the erosion of purchasing power and profit margins by provisioning wages and prices.
When, in addition to rising, inflation becomes persistent, the incentive for indexation and the frequency of readjustments increase.
On the other hand, price dynamics in a low-inflation regime offer greater flexibility to central banks. In this regime, the evolution of inflation largely reflects changes in relative prices that can be accommodated through a less active monetary policy, with less risk of contamination of other prices.
After three years of high inflation, Brazil is in danger of re-entering a high-inflation regime. We managed to approve the autonomy of the Central Bank last year, but unfortunately we have a great chance of missing the top of the inflation target for three consecutive years.
There is no way not to see some loss of credibility with this history.
It is true that Brazil’s real interest rates are extremely high today, but the same can be said of inflation, inflationary expectations and fiscal uncertainty.
The longer we delay controlling inflation, the greater the deceleration of the economy needed to bring it back to price stability.
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