Brazil accelerates tightening cycle with 100bp rate hike

The Central Bank of Brazil accelerated the tightening cycle it started in March in a bid to control rapidly rising inflation.

On August 4, the monetary policy committee increased the key Selic rate by 100 basis points to 5.25%, and signalled that another 100bp increase is likely in September. In 2021 so far, the central bank has increased rates by 325bp.

These efforts aim to rein in high and rising inflation. In June, inflation increased year on year by 8.4%, the highest level in five years, according to official data. The inflation target this year is 3.75%, falling to 3.5% in 2022 and 3.25% in 2023.

“The committee understands that, at this moment, the strategy of a quicker monetary adjustment is the most appropriate to guarantee the anchoring of inflation expectations,” says the policy statement. “Without compromising its fundamental objective of ensuring price stability, this decision also implies smoothing of economic fluctuations and fosters full employment.”

Several factors are contributing to higher inflation, including rising energy costs. An acute drought has lowered reservoir levels at some hydroelectric dams, prompting authorities to resort to more expensive thermoelectric power.

Additionally, the reopening of the economy is boosting demand while supply is readjusting to higher levels of activity.

“We see upside risks to inflation coming from both the supply and demand sides,” says Marcos Casarin, chief Latin America economist at Oxford Economics. “On the supply side, profitability is squeezed by the costly safety protocols needed for reopening during the pandemic, forcing firms to pass along cost increases to final consumers.”

The analyst points out the scarcity of semiconductors, metals and other inputs is contributing to higher production costs. To make matters worse, since 2019, the real has fallen 20% against the dollar, fuelling import prices.

Demand is being reinforced by the government’s cash transfers to households. These have hit 428 billion real ($83.6 billion). The programme has boosted the M2 money supply to 54% of GDP, the highest since the end of hyperinflation in 1995, according to Casarin.

“The confluence of generous fiscal and monetary stimulus was the key driver behind Brazil’s fast recovery, but it is now backfiring in the form of higher, more widespread inflation,” says the Oxford Economics analyst.

Partly thanks to the hefty fiscal stimulus implemented by the right-wing populist government of president Jair Bolsonaro, in 2020 the economy contracted by only slightly over 4% of GDP. In Mexico, where the government shied away from this kind of largesse, GDP shrank by 8.2%.

The central bank now expects inflation to average 6.5% this year, 3.5% in 2022, and 3.2% in 2023. This scenario assumes the Selic rate will rise to 7% in 2021, remaining at that level during 2022, only falling to 6.5% during 2023.

Risky scenario

The central bank stresses risk to its inflation outlook remains in both directions. For instance, a fall in commodity prices in local currency would reduce inflation pressures, says the policy statement.

On the other hand, further fiscal stimulus would boost aggregate demand and worsen Brazil’s fiscal outlook.

“In spite of the recent improvement of debt sustainability indicators, the elevated fiscal risk creates an upward asymmetry in the balance of risks, ie, in the direction of higher-than-expected paths for inflation over the relevant horizon for monetary policy,” says the central bank.

Brazil’s public debt increased from 87% of GDP in 2019 to 99% last year, a very high level for a middle-income economy.

This outlook could further worsen if the government implements Bolsonaro’s plan to double the size of Bolsa Familia, the cash-transfer programme to low-income households.

“It could cost around 0.4% of GDP. Not gigantic, but would make it even harder to find offsetting cuts and meet a tight spending rule,” says Sergi Lanau, deputy chief economist at the Institute of International Finance. He expects spending to exceed fiscal rules next year, something he says is an “electoral reality”.

Brazil’s next presidential elections are due in October 2022, and Bolsonaro faces very low levels of popularity, partly reflecting Brazil’s high mortality rate during the Covid-19 pandemic.

This challenging fiscal and political context will likely force the central bank to tighten its policy further in order to tame inflation, thinks Casarin. “We expect Brazil’s central bank to go on the offensive and hike the Selic policy rate all the way to 8% at the end of the cycle,” he says. “Higher inflation will not be as transitory as the central bank might have wished … the central bank will have to act boldly to maintain credibility.”

Casarin notes the central bank’s falling inflation target means it will have to work even harder. Not only does it need to stop inflation expectations rising – they must also fall in the years ahead.

Furthermore, the neutral interest rate is rising. The consultancy firm estimates the nominal neutral rate will jump to 7% in 2022. This means that if rate-setters want to adopt a contractionary stance they will have to take rates over that threshold.

The fiscal outlook seems to indicate last year’s stimulus is unsustainable, which raises a question mark over the growth prospects of Latin America’s largest economy.

“Last year’s overperformance was driven by expansionary fiscal policy,” says Lanau. “This year, a negative fiscal impulse of -6% of GDP will at times weigh on the recovery.”