Central Bank of Brazil likely to keep policy on hold; inflation trajectory for 2017 uncertain

The Brazilian central bank is likely to keep its policy on hold during the June Copom meeting. The Central Bank of Brazil has maintained its benchmark Selic rate at 14.25% since the fourth quarter of 2015. Worsening of economic growth has kept the central bank from severely interfering and further tightening the policy, even when inflation and expectations of inflation continued to be high until February 2016.

Lately, it appears that the central bank might begin easing monetary policy in 2016 given that the inflation is decelerating due to base effect and declining expectations of inflation. But, there is a strong likelihood that inflation will remain more than 7% in 2016. Also, the path of inflation for next year is quite uncertain due to the lack of base effect and because several external and domestic factors determining inflation expectations might not be favorable, said Societe Generale in a research report.

With the subdued economic growth and weakness in labor market, inflation might moderate further next year. This argument favors the easing of monetary policy. Moreover, the relative stabilization of Brazilian real is likely to aid inflation expectations and inflation. The argument that is against easing of monetary policy concentrates on fiscal risks. Even if a high fiscal deficit results in low domestic savings accelerating inflation structurally, it can also concern investors regarding the sustainability of public finances. This might lead to exerting pressure on the real and inflation expectations again, noted Societe Generale.

If the Brazilian government comes up with estimates for spending and credible revenue, which targets a fiscal path that can be maintained, the central bank can ease more than projected right now. But the fiscal path is quite uncertain amidst the present growth scenario. It will be challenging for the Brazilian government and the central bank to lower rates without letting go of credibility, especially if inflation continues to be stubborn because of renewed pressure on the real or structural shortages.

Meanwhile, the Central Bank of Brazil will be wary in significantly easing of policy in 2016 given that the US Fed is expected to hike rates. However, the central bank is unlikely to substantially ease policy on the horizon, according to Societe Generale.

“Despite revising down our rate forecasts recently – expecting a 25bp rate cut this year followed by a 150bp rate cut next year – we see interest rates staying much higher than market expectations”, added Societe Generale.