COPOM rate cut clouds view of ‘reaction function’

Since the committee formally began targeting the 18-month-ahead window for monetary policy in mid-2024, this was the first time the benchmark rate and inflation projections moved in opposite directions. The decision has raised caution among market participants, who now see less clarity in the Central Bank’s reaction function.

With the inflation picture worsening significantly after the oil shock caused by the war in the Middle East, investors believe the COPOM is betting that oil supply will normalize and is trying to preserve the easing cycle to gain time, a strategy that could become costly later.

That view is shared by Juliano Cecílio, chief economist at asset manager Adam Capital, who disagrees with the decision to keep cutting the Selic amid current inflation above target and unanchored inflation expectations, both in the market and at the Central Bank itself. He also notes that Brazil’s economy was already feeling the effect of a significant fiscal impulse, which supported activity and service prices throughout 2025 and early this year.

“We had the largest forecast error in the IPCA’s historical series in February, before the war began, and that was basically caused by service inflation,” Cecílio said, referring to Brazil’s benchmark consumer price index. “Right after that, when the war came, a narrative emerged that expectations rose only because of that [in the Central Bank’s Focus survey], but before the conflict there was already a series of fiscal stimuli and an acceleration in service inflation.”

The three-month moving average of annualized and seasonally adjusted underlying services inflation, a less volatile measure than the monthly reading and widely used by the market, shows signs of acceleration. The measure stood at 4.74% in December, 5.41% in February, and 5.32% in March. Some firms estimate that April’s IPCA may show a new acceleration in underlying services inflation, to around 5.7%.

For Cecílio, the oil shock acted as a “smokescreen” that kept the Central Bank from identifying the core problem: “An economy strong enough to prevent service inflation from cooling or to keep it accelerating.”

More tolerance

Cecílio also sees greater leniency by the monetary authority toward the worsening inflation forecasts, although he says the phenomenon is neither new nor limited to Brazil. A study by Adam Capital shows COPOM’s sensitivity to deteriorating projections has declined since the pandemic, a trend also seen at major central banks such as the Federal Reserve.

“In 2026, we mark the sixth consecutive year in which the PCE deflator [the Fed’s preferred inflation gauge] is above the 2% target. That is an unusual situation,” Cecílio said. “The Central Bank [of Brazil] looks at these post-pandemic examples of greater tolerance for inflation deviations, and that helps explain this looser reaction function.”

Cecílio said reduced sensitivity to expectations has already led to monetary-policy mistakes in recent years, including the Selic-cutting cycle in 2023 and 2024, which was followed soon after by a 450-basis-point increase in the benchmark rate between September 2024 and June 2025.

“Central banks did not make bets in the past. They always worked with the most conservative premise possible, and that no longer seems to be happening,” Cecílio said. He sees the COPOM losing credibility in the current rate-cutting cycle, as longer-term IPCA expectations become further unanchored.

Since the start of the war, the median Focus survey forecast for 2028 inflation has risen to 3.64% from 3.5%, a development the COPOM itself has flagged with concern in its recent communication.

Clearer threshold

The additional drift in inflation expectations was highlighted by BTG Pactual as a warning sign for monetary policy. “The deterioration reduces the comfort to extend the cycle without making the reaction threshold clearer, that is, which conditions would lead to a pause, an end to the cycle, or greater restriction. Without that, the risk increases of further deterioration in the anchoring of expectations and in the credibility of communication,” economists Tiago Berriel and Iana Ferrão said.

In a note to clients, they said the Central Bank’s reaction function has changed and has become “harder to infer.” BTG believes qualitative judgment now carries more weight in the monetary authority’s decision-making process, while projections provide less guidance on the next steps for interest rates.

“It has become less clear what [level of] deterioration in projections, expectations, or core measures would lead the COPOM to stop the cycle,” Berriel and Ferrão said. That is because the current Selic-cutting cycle rests on two points: the extended period of monetary restriction and a greater qualitative assessment of how persistent the shock caused by the war in Iran will be.

For Ian Lima, active fixed-income manager at Inter Asset, the Central Bank is trying to buy time to better understand the effects of the oil shock on Brazil’s economy while preserving the easing cycle and signaling a bias toward further Selic cuts in upcoming decisions. “By continuing to ease, the Central Bank keeps the interest-rate market pinned down in some way. If it pauses the cycle, the market could flirt with a Selic hike, and that would tighten financial conditions, which it does not want to deliver. It is a bet, but it is easier than for other central banks in Europe and Asia,” Lima said.

Lima sees the impact of the war on Brazil as milder and says the Central Bank has “fat to burn” after raising the Selic to 15% last year, its highest level in almost two decades, and holding it there for nine months.

“Some say the increase to 15% was made precisely to put [interest rates] at a restrictive level beyond any doubt,” Lima said. Brazil’s real interest rate is now around 10%, well above most market estimates of the neutral rate, which stand near 6% to 7%.

“I think this slow cycle of cuts fits the current context. The COPOM has some fat and is burning it. If it had left the Selic unchanged at 15%, expectations would be rising because of oil, and it might have had to raise rates,” he said.

Room for cuts narrows

Still, the space for further Selic cuts has narrowed “substantially,” said Aurélio Bicalho, chief economist at Vinland Capital. He said the Central Bank is “acting in a way that manages some of this uncertainty and tries to continue the cycle for some time.” In the asset manager’s monthly call, Bicalho said the Central Bank is likely to keep lowering the Selic at the current pace of 25 basis points until September.

Although he agrees that monetary policy has been working to cool activity, a point emphasized by the Central Bank, Bicalho said that has never been used as a justification for easing interest rates. He noted that Brazil is part of a group of countries with high inflation, unanchored expectations, and credibility problems at the monetary authority, which should force the COPOM to pause the cuts before the last quarter.