Brazil - Revision of fiscal targets means monetary policy remains key tool for fighting inflation

It is expected that, the Selic rate to peak at 14.50% in Q3, including a 50bp rate hike today to 14.25%. However, significant upside risk persists due to the uncertain inflation outlook in the medium term. A significant cause of upside risk is the mounting fiscal concerns that are leading to pressure on the BRL. This will eventually affect inflationary expectations, although as we have seen in the past, actual inflation has almost always exceeded expectations by a fair margin. The recent downgrading of fiscal targets was a near formality, since those targets were practically impossible to achieve given the current macro environment and legislative hurdles. This clearly indicates that monetary policy will remain the key tool for fighting inflation in this cycle, with fiscal lapses remaining the key long-term structural concern.

While inflation has continued to accelerate this year and average 2015 inflation have also risen currently heading towards 9.0% versus our forecast of 8.4%, there has been substantial moderation in the 2016 consensus inflation view. While inflation is moderating in 2016, on a strong base effect, it is expected that, inflation will fall close to the BCB's target by the end of 2016. Moreover, year-ahead inflation expectations have often been proved wrong, and analysts have generally underestimated inflation in recent years.

"The in-sample forecasts from our structural inflation models put Q2 inflation at 7.0-7.2%, which is much lower than the actual inflation of 9.25% yoy. The difference in the figures arises from the effect of price adjustments and the upside shock to food prices. While the escalating upside risks implies that the medium-term inflation outlook remains uncertain, the model estimates suggest that inflation is fundamentally trending upward" says Societe Generale.