Brazil central bank could ‘test’ lower rates if inflation remains weak – IMF

There is room for the Central Bank of Brazil to cut interest rates further if inflation and inflation expectations remain below target, according to a new report from the International Monetary Fund.

Since the start of the year, the central bank has cut the policy rate 225 basis points to 2% in response to the Covid-19 pandemic.

But staff from the IMF believe the central bank has been “cautious”, and should inflation remain low, and inflation expectations anchored, interest rates may need to be lowered further.

“Inflation dynamics are expected to remain subdued and with little exchange rate pass-through,” IMF staff say in the report. “[We] see no constraint to test lower rates while monitoring possible implications for capital flows and financial stability.”

According to staff, a Taylor rule analysis suggests there is still room for the central bank to ease policy, but rate cuts should be combined with forward guidance to signal rates would stay lower for longer.

However, some IMF directors cautioned about the potential trade-offs from further rate cuts given the “unprecedentedly low level of the policy interest rate”.

“The recent uptick in market-implied inflation expectations for 2021–23, with 2023 expectations now above target, should be tracked carefully,” IMF staff said.

In June, the central bank’s monetary policy committee (MPC) decided it had approached the limit of its monetary policy easing. Any further interest rate reduction, the MPC said, could be accompanied by asset price instability.

Monthly CPI inflation turned negative in April and May this year; it returned to positive territory in the second half of the year, rising to 2.4% in August. However, inflation is expected to stay below the central bank’s 3–6% target until 2023 under the IMF’s current forecast.

The central bank has said it will not raise interest rates while inflation expectations and the MPC’s projections are below target.

IMF staff note recent price pressures have led market expectations for 2020 inflation to increase from 2.65% to 3.25%, with a smaller increase to 3.22% for 2021.

“While those pressures are mostly localised and temporary, the [central bank] will continue to closely monitor all relevant indicators,” said Afonso Beviláqua, executive director at the IMF.

Reserve requirements made permanent

In addition to cutting rates, the central bank also lowered the reserve requirement ratio (RRR) for banks to 17%, which the IMF believes could be made permanent.

In March, the central bank cut the RRR from 32% to 25%, following which it adopted an additional temporary reduction to 17% to provide liquidity to the banking system. Plans are currently in place to increase the ratio to 20% in April 2021.

“If the implementation of a new Emergency Liquidity Assistance (ELA) facility proceeds according to schedule, keeping the RRR at 17% would reduce banks’ liquidity costs permanently, and contribute to lower borrowing spreads,” IMF staff said.

Brazilian authorities said the decision regarding the appropriate level of the RRR would be made under the scope of the central bank’s institutional agenda moving forward, and not related to the pandemic. They still plan to raise the RRR to 20% next year.

Autonomy in focus

IMF staff also recommend Brazilian authorities establish a committee with an explicit mandate for macro-prudential policy. The committee would have representatives from various regulatory agencies.

This committee would have the power to issue recommendations on a “comply or explain basis”, the IMF said.

The central bank has already finalised a draft bill named the ‘Financial Stability Coordination Law’, which is currently being analysed by the office of the president’s chief of staff.

Two bills that tackle the central banks’ autonomy are also under discussion by Brazil’s Congress.

One bill has been approved by the Senate, which addresses the central bank’s mandate, including the criteria for appointing and the dismissing governors, and sets four-year tenures (with one renewal) for the board of governors.

The law also ensures a governor’s tenure does not match the presidential term, to avoid politically-charged appointments whenever a president is elected. The IMF said this will strengthen the independence of the central bank. This bill has moved to the lower house.

The second bill, submitted to the lower house, is broader and proposes legal protection of central bank staff and defines aspects of operational autonomy.

It also addresses the delegation of decisions about other monetary policy and macro-prudential tools from the National Monetary Council to the central bank and enhances policy transparency. This bill has not yet been evaluated due to the pandemic.