Luiz Fernando Figueiredo and Rafael Ihara: Inflation should only return to target in 2023

Inflation closed the last year at 10.1%, the highest rate since 2015, when inflation was 10.7%. In order to analyze the prospective behavior of inflation, we must first understand what are the main vectors of current inflation.

Administered price inflation, those defined by contracts or regulated by the government, was 16.9%, also showing the highest annual variation since 2015. Within this group, the largest contributions came from gasoline (up 47.5% in the year ) and residential electricity (up 21.2%).

Fuel prices reflect the variation of the dollar, which rose about 10% in 2021, and oil, which rose more than 50%. With the market easing fears around the omicron variant, we should see oil price pressure in the short term, but it seems quite unlikely that we will see a rally of the same magnitude as last year throughout 2022.

Regarding the exchange rate, the current scenario is of a strong dollar with the US leading global growth and the Fed increasingly hawkish. However, our exchange rate already has a high premium and it is not absurd to think that we could even see a fall in the dollar if there is any sign of economic rationality on the part of the presidential candidates. In relation to electricity, the improvement in the water scenario should represent a relief in the inflation of this item throughout the year.

Among market prices, which reflect supply and demand conditions, the bullish highlight is goods inflation, which closed the year at 12.0%, the highest rate in the recent series. This pressure on the price of goods is directly linked to the pandemic, with supply issues, such as the lack of inputs or logistics problems, and demand, as given the impossibility of consuming services, consumers have increased demand for goods.

It is worth noting that the monetary stimulus made throughout 2020 and the aid granted further boosted this demand for goods. The normalization of the consumption basket should occur throughout this year. In addition, the withdrawal of stimuli, with the reduction of aid and the ongoing monetary tightening, should contribute to the cooling of inflation of goods in 2022.

Services inflation closed 2021 at 4.8%. Considering the variation of only 1.7% in 2020, we have the average of these 2 years running at 3.2%, the same level as the two previous years. This group is the most sensitive to the labor market, which should end 2021 with the unemployment rate a little below 12% – a level well above the Nairu (a rate compatible with the stability of inflation), which we estimate at 9.5%.

It is important to emphasize that the labor market reacts with a lag to the economic cycle. Therefore, the effect of weaker activity in the second half of 2021, in addition to the monetary tightening made over the last year, should only have an impact on unemployment this year.

Finally, food inflation ended 2021 with an increase of 8.2%, a very high level, but still lower than that seen in 2020 (18.2%). External inflation, measured by the behavior of agricultural commodities in reais, tends to help domestic dynamics this year. In addition, despite recent news of drought in the South and Central-West regions, there is still the expectation of a favorable harvest, which should contribute to well-behaved food prices throughout the year.

Looking at core measures, which attempt to capture price trends by excluding items that are more volatile or less sensitive to the business cycle, we are already seeing a cooling off since the peak in October last year, when the 3-month moving average of the BC reached 10.6% (seasonally adjusted and annualized), to 9.4% in December. Although it is still running well above the target, keeping the trend of the last few months and considering the above scenario, we should see the core measures approaching the target throughout this year.

Thus, inflation should end 2022 close to 5.0%, above the target of 3.5%, but showing a significant deceleration in relation to 2021. Political and fiscal noises have posed a monumental difficulty for the BC to tame expectations of inflation, in such a way that we saw here the most aggressive monetary tightening cycle in the world last year. In this way, we should only see inflation returning to the target in 2023, when we should also see a cycle of interest rate cuts. Naturally, we are dependent on the political scenario in the expectation of a reasonable economic agenda for the presidential candidates.