Inflation Showdown

By Gray Newman | New York

In July, Brazil's central bank faced significant criticism when it slowed the pace of its rate-hiking cycle - a cycle that had just begun in April - and prepared to stop hiking all together at its next meeting. The abrupt end to the hiking cycle was difficult to understand. After all, the factors triggering the start of the rate-hiking cycle in April - robust domestic demand, fiscal stimulus ahead of the October elections, and rising inflation expectations - all remained in place in July. 

We were puzzled as well. While we noted that domestic production had started to slump, domestic demand (which is a much more important driver of inflation) remained 'red hot'. Some argued that political forces were beginning to set the monetary policy agenda. We argued that however difficult it would be to handicap near-term policy decisions - we ended up removing any hikes from the remainder of 2010 - we expected that the central bank would have little choice but to resume hikes in 2011 (see "Brazil: Slowdown - Comfort or Caution?", This Week in Latin America, July 26, 2010). Our call that rates would need to rise to 12.5% in 2011 was widely questioned at the time.

Now, just a month to go before the new administration takes office - and a new central bank governor, Alexandre Tombini takes over as new central bank head - the mystery of July appears to be resolved, at least in part. The abrupt end in the hiking cycle came as the central bank uncovered evidence of possible fraud at the country's 21st largest lender and began to investigate to see if others were also involved. The central bank admits that there were "absolutely legitimate" questions regarding its abrupt end in the hiking cycle, but argues that it could not divulge news of the troubled bank pending its investigation. The implication of course is that with the resolution of the central bank's investigation into the troubled lender (no other lenders have been implicated), the central bank can resume its hiking cycle. 

Indeed, Brazil's interest rate markets, which only a few months ago had been sceptical of rate hikes in 2011, are now beginning to price in rate hikes as early as the next meeting that concludes on December 8. And inflation readings - last week's reading of the leading consumer price index, the IPCA-15 (November) posted its second-largest gain (0.86%) for the year - have raised considerable concern that Brazil is facing a major inflation problem.

While we reiterate our forecast that the central bank is likely to restart its rate-hiking cycle in 2011, we would warn against exaggerating the inflation challenge facing Brazil as well as the policy response. Four thoughts are in order. 

First, a significant portion of the uptick in inflation as measured on an annual basis may be short-lived - year-over-year inflation is set to rise during 4Q and fall in 1Q11. Indeed, if we set inflation for each month beginning in 4Q with the average (seasonally adjusted) pace seen in 1H10, you would see year-over-year inflation rise by 70bp trough to peak from August to December 2010 and then drop by 70bp through April 2011. The 'uptick' as measured by the annual inflation reading in 4Q would no more tell you about inflation dynamics in Brazil than would the sudden 'downturn' in the first months of 2011.

Of course, inflation in October and November are rising above the seasonally adjusted average of the first half of the year. Our exercise is not designed to argue that inflation is not a concern, but only that the annual numbers released for October and to be released for November and December may exaggerate the worsening just as next year's readings for the first four months of the year may exaggerate an improvement.

Second, most of the uptick in the annual readings has been concentrated in food: precisely where you should not be focused. While we have seen some broadening in the number of goods facing a larger price increase, the biggest change in recent months in the overall consumer price index (IPCA) has come on the food front. Food IPCA has risen from a 4.1% annual reading in August to just under 7.5% in October. While food prices have responded to global pressures, the uptick has been exaggerated again, given the base of comparison used for the annual readings. Unless you expect to see another major move up in food commodity prices (not the base case for our commodities team, which believes that most prices have peaked), Brazil's food inflation should show signs of easing in the coming months.

Third, the much bigger concern that we have been highlighting since mid-year is that domestic demand continues to grow at a much faster pace than domestic production (the 'growth mismatch'). A prolonged period in which demand exceeds supply is likely to lead to higher inflation (as demand outstrips supply), a greater current account deficit (as a portion of demand is met with imported goods and services) or both. Brazil's growth mismatch can clearly be seen in both the growing current account needs as well as in worrisome services or non-tradable inflation (see "Brazil: Financing Mismatch", This Week in Latin America, October 18, 2010). The real problem facing the next administration's policy-makers is not that food prices have temporarily risen - in part the effect of base periods of comparison and largely due to external factors outside the purview of central bank policy - but that services inflation has been running above 7% for much of 2010 and well above the overall 4.5% inflation target. (Indeed it is the strength of the Brazilian real which has helped keep tradable inflation down. Recall that Brazil, unlike many other emerging economies, is a major exporter of foodstuffs and rising dollar prices have helped to strengthen the Brazilian real, thus tempering the impact on local prices - that is, of course, when the authorities are not limiting the strength of the currency.) 

Finally, while we expect the central bank to restart the hiking cycle that was cut short after the July decision, we still have questions regarding the reaction function of the new leadership which takes control in January. We have little doubt that if the current team remained in place, the central bank would resume interest rate hikes - as early as this month or, if not, in January. But we believe that there is a difference in view among some of the key policy-makers in the next administration, which are intent on lowering Brazil's real (and nominal) interest rates, with the more immediate task at hand for the central bank. This can be averted if the central bank makes clear that its actions in early 2011 are in response to the business cycle and does not openly contradict the longer-term, structural view in favour of lower interest rates. 

The key for Brazil to be able to reduce interest rates on a structural basis is likely to lie not with monetary, but with fiscal policy. Brazil's overall fiscal stimulus in late 2010 was little changed from where it stood in mid-2009, despite the rapid rebound in demand. The fiscal authorities have recently suggested that a significant fiscal adjustment will take place at the beginning of the next administration. That indeed would be positive and could pave the way for a structural shift away from the current mix in Brazil, which has been dominated by loose fiscal and tight monetary policy. But again, we await more details from the finance authorities. In contrast, talk from some policy-makers of a new core inflation measure that would show less inflationary pressure is more worrisome. We think that Brazil's current mix of monetary and fiscal problems demands a structural rethinking of fiscal policy, not simply a new inflation measure to add to the myriad of inflation indices already present in Brazil.

Bottom Line

Once again all eyes appear to be on Brazil's central bank as Brazil-watchers await for clues as to when the new leadership will respond with a rate hike. We suspect that the excessive focus on the central bank and its policy response is misguided. Brazil has a chance to rethink the balance between tight monetary and loose fiscal policy - that is the much bigger macro challenge facing policy-makers, in our view. Absent significant progress on that front, the next central bank will likely find that it has limited degrees of freedom.