Brazil: Finally, that elusive rate cut Global Economic Outlook, Q4 2016

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Brazil's central bank cut its key policy rate for the first time in four years in October. After the recent tumult in the economy, a decline in interest rates should be a welcome break for consumers and businesses. But any further cuts depend on inflation, which is still higher than the bank's target range. 

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In October, Banco Central do Brasil (BCB) cut its key policy rate (Selic rate) by 25 basis points from a 10-year high of 14.25 percent.1 The central bank had last cut the Selic rate in 2012. In recent weeks, economists and markets closely followed BCB moves, wondering when the central bank will bring down the cost of borrowing to provide some succor to the economy. After all, fiscal support in the short to medium term is unlikely given the high fiscal deficit and growing government debt. And the economy has gone through a tumultuous period of political uncertainty, with long-term confidence in the new government yet to be tested despite initial cheers from the markets.

It appears now that the BCB has finally obliged. However, it would be naïve to assume that the October rate cut indicates a path to continued monetary loosening in the near term. In fact, the quantum of the rate cut—25 and not 50 basis points—indicates that BCB is wary of inflation, which, at 8.5 percent, is still much above the central bank’s target range of 3.0–6.0 percent.

The economy has gone through a tumultuous period of political uncertainty, with long-term confidence in the new government yet to be tested despite initial cheers from the markets.

Consumers in need of some help

Brazil’s economy contracted 0.6 percent quarter over quarter in Q2, the sixth straight quarterly decline (figure 1). While the pace of contraction has slowed, it will be some time before growth turns positive. In the central bank’s October 7 survey, for example, the median growth forecast for 2016 was -3.2 percent, with growth likely to move up to 1.3 percent next year.2 The International Monetary Fund (IMF), however, puts its growth forecast for 2017 much lower at 0.5 percent, although its July forecast is an improvement from its April number.3

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A key worry for economic activity is consumer spending. Once a poster boy for growth, consumer spending contracted yet again in Q2. Spending by consumers is also likely to remain subdued if trends in monthly retail sales are anything to go by: Sales volumes fell 0.6 percent in July and August, reversing a 0.2 percent gain in June. Consumers have been battered by rising unemployment and high inflation. Real average monthly earnings, for example, have been in decline since early 2015, and the unemployment rate went up to 11.8 percent in July and August (more than three percentage points higher than a year before).4 Worse, the labor market is unlikely to improve soon as the economy is not poised for a strong recovery in 2016–17.5

With the fiscal side set to remain tight—subsidies have been cut, and proposed reforms will hit welfare spending—the onus will fall on monetary policy to stimulate consumer demand. Any rate cut will aid credit creation by lowering the cost of finance. Credit growth has been moribund due to high interest rates and slowing demand (figure 2). A cut in interest rates will also help consumers who are eager to deleverage. Households had gone on a spending binge a few years ago due to cheap credit from state development banks. Between 2005 and 2015, for example, household debt as a share of disposable personal income went up by about 25 percentage points, while the debt service ratio shot up by more than 5 percentage points.6

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With the fiscal side set to remain tight—subsidies have been cut, and proposed reforms will hit welfare spending—the onus will fall on monetary policy to stimulate consumer demand.

Businesses, too, need some help

The weak economy and political turmoil have hit domestic demand and, hence, corporate profits. Businesses have also been hurt by the high cost of capital, which in turn has dented credit for the private sector. Credit growth for nonfinancial corporations, for example, turned negative in May (figure 2). All these factors have hit investments severely. Gross fixed capital formation fell 25.6 percent in the last three years and has contracted every quarter since 2014 barring Q2 2016.

The drop in business activity can also be seen in growth trends in manufacturing and services. Manufacturing has contracted 18.1 percent in the three years up to Q2 2016, with services managing to grow just 5.1 percent during this period. Even in services, a weak economy is taking its toll, with growth falling to -0.8 percent in Q2 from -0.4 percent in Q1. Add to this the private sector’s long-running grievances over ease of doing business—especially the taxation regime—and one can sense a classic case of a prolonged low-investment environment. This does not augur well for productivity and potential GDP growth.

The dark clouds for businesses, however, appear to be thinning a bit. The political environment, a cause for much of the uncertainty over the last year, has improved, with the new government expected to continue in office until 2018, when presidential elections will be held. Markets have reacted favorably to the new economic team in place, with long-term bond yields going down. Business confidence has also improved (figure 3). So any drop in the cost of capital, courtesy BCB, will add to the rising optimism.

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Markets have reacted favorably to the new economic team in place, with long-term bond yields going down. Business confidence has also improved.

For BCB, inflation numbers are a worry

Inflation has been one of the sore points of BCB’s monetary management. The last time inflation hit the midpoint (4.5 percent) of the central bank’s target range was way back in August 2010. It is no wonder, then, that BCB’s credibility has been hit. The central bank will thus be more cautious in its approach going forward. While both headline and core inflation figures have come down this year, the pace of decline slowed in July and August; the figures for August were slightly higher than the ones for July (figure 4). Thankfully, inflation declined slightly in September, and so did core inflation, probably influencing BCB’s October rate cut decision.

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A quick look at the components gives us a mixed picture. Food inflation, for example, continued to be high in September, but fell on a month-over-month basis—a positive sign given the component’s large share in the headline price index. Services inflation, which had gone up in August, probably due to price hikes during the Olympics, fell in September. Moreover, growth in regulated prices, which include utilities, public transportation, and fuel, has also gone down this year. Regulated prices had spiked in 2015, as the government cut subsidies. So, toward the end of this year, a high base effect is likely to come into play here.

Contrary to 2015, the currency’s strength will be helpful in pushing down inflationary pressures. Since the beginning of the year, the Brazilian real has gained more than 22.0 percent against the US dollar to emerge as one of the best-performing emerging-market currencies. Although worrisome for exports—that sector has been the lone light this year—a strong real is likely to push inflation lower.

Time for the fiscal side to deliver

In August, Dilma Rousseff was officially impeached, paying the way for President Michel Temer, her former deputy, to continue in office for the next two-and-a-half years. Temer’s economic team has so far found a vote of confidence from the markets: Equities are up, and bond yields have gone down. Markets are particularly enthused by his reform proposals, both fiscal and structural. The proof of the pudding, however, is in the eating. Some of these reforms will be difficult to pass and may be unpalatable for a population reeling from severe economic contraction.7 The proposal to cap real government spending, for example, may require cuts in other social welfare programs. Reforms in pensions, where costs are expected to soar over the next decade, will be even more difficult.

For now, some reforms are likely to get legislative approval because of the numbers in favor of Temer. The dire state of public finances may also strengthen the government’s hand. Markets will be watching with interest.Any dithering by the government is likely to reverse gains made in equities and bonds so far, which, in turn, could impact inflation expectations and force BCB to be more cautious. For example, even though inflation expectations for the next 12 months have gone down to 5.1 percent in October from 7.1 percent in January, the figure is still above BCB’s midpoint target. As BCB President Ilan Goldfajn recently pointed out, inflation expectations will decline toward the target only if there are better fiscal management and economic reforms.8 That will, however, take some time. Until then, BCB is likely to tread a cautious, data-dependent path.