The Brazilian central bank’s 50 basis point reduction in its benchmark Selic interest rate on Wednesday night, taking it to a record low of 8.5 per cent, could hardly have been more widely anticipated by economists.
In a unanimous vote, the bank’s monetary policy committee cited the limitations to the upward trajectory of inflation domestically and the disinflationary winds sweeping in from a weak global economy.
Moody’s Latin America director Alfredo Coutiño, had this to say:
After today’s decision, monetary conditions have fallen below neutrality, since the nominal policy rate is lower than the neutral 9 per cent. If economic activity remains weak and advances slowly, monetary conditions will need to be pushed further into expansionary territory in coming months. Lower interest rates will restore the currency competitiveness and will help the national industry to quit recession.
The question now is how much further can rates fall from here? The answer is another 75 basis points, according to Bank of America Merrill Lynch. The bank’s Brazil economist, David Beker, had this to say in a report released earlier this month:
Following the changes in savings accounts, we revised our Selic terminal rate to 7.75 per cent from 9 per cent. We expect the central bank to deliver two consecutive cuts of 50bp in May and July, and one last cut of 25bp in August.
This opens the question of whether the cut in rates is cyclical or structural; that is, will these cuts have to be at least partially reverted later on? To answer this question we use our model of neutral real rates.
In October 2010, we concluded that neutral real rates in Brazil were 5.4 per cent, under normal global rates of growth and a potential GDP growth of 5 per cent for Brazil. We also estimated that neutral rates dropped almost linearly with global growth in Brazil’s case; that is, for each percentage point of lower global growth, neutral real rates drop by 1 per cent in Brazil.
Our forecasts for global growth are about 3.6 per cent for 2012 and 2013, or about 100bp lower than pre-2008 crisis levels. We also now estimate that in the next few years potential GDP growth has slowed down to about 3.8 per cent in Brazil. This implies a neutral real rate of 2.6 per cent and a nominal neutral rate of 7.8 per cent, using the consensus inflation forecast of 5.25 per cent for 2013. This means that our Selic forecast implies taking policy rates to neutral levels, which is at least what is needed if the output gap is really negative as our analysis suggests.
Given our expectation of higher inflation in the second half and 2013, we expect the central bank to hike rates in our central scenario. We expect three hikes of 50bp in the second half of next year, bringing rates to 9.25 per cent.
So the answer is that Brazil’s President Dilma Rousseff, a staunch champion of lowering Brazil’s interest rates, will see her wish granted for the next year or so. But if Brazil begins to begins to grow again at above its “potential” rate of 4.5-5 per cent, then expect the return of double digit rates.
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