Russia’s invasion of Ukraine further exacerbates global inflationary pressure, but central banks are not all likely to respond in the same way. In Brazil, the most likely prescription is more interest to tackle rising prices, without much room to look at economic activity.
Over the last few weeks, the foreign exchange rate had been having an unusual behavior in Brazil, falling to R$5 to the dollar on Wednesday. This positive view in the exchange market overshadowed the latent tensions in the interest market, where the geopolitical risk was more strongly expressed.
Economists who did the math concluded that even with a stronger real, commodity prices in reais were on the rise, especially grain and energy. Russia’s invasion of Ukraine made these prices jump again and, at least in this first moment, the exchange rate also responded upwards.
Even before the crisis worsened, some economic analysts suspected that the appreciation of the real was temporary. There are, however, many good people in the market who argue that the real was undervalued, and the exchange rate would eventually fall. But the controversy was somewhat less about inflation and how the Central Bank should react.
The February inflation forecast was higher than expected, and the index, qualitatively speaking, was not good. The Central Bank itself had already been highlighting surprises in services inflation, the most dangerous of all because it is the most resistant to falling.
The invasion of Ukraine means the prolongation and intensification of the price shock caused by the pandemic, from which we had not yet rid ourselves. The risks of further contaminating the long-term trend of inflation increase, and the Central Bank has less room to lower its guard and be flexible in taking care of the economic activity.
In developed economies, the equation is different, and the risks of monetary policy error are huge. The long-term yield curve in the United States, which is not so steep, reflects a lot of these uncertainties.
When the U.S. Federal Reserve Chair Jerome Powell signaled that all possibilities were on the table to combat inflationary pressures, the market began to adjust the yield curve.
The shorter vertices rose more, but still without pricing in a rate hike above the neutral level, currently estimated at 2.5% per year. Many thought this was not enough, given the immense challenges for the Fed, with inflation at 7.5% a year in the U.S., a labor market at full capacity and strong wage growth.
There was also the stubbornness of longer-term interest rates, which, at most, remained around 2% per year. There were several theses in the market to explain this. A popular one was that the Fed would overshoot to counter a temporary price shock before being forced to back off.
After the invasion of Ukraine, the interest rate on ten-year U.S. Treasury bonds fell below 1.9%. Two stories can be told. One is that this is a typical risk-aversion move, when everyone goes to the U.S. bond and the interest rate falls. Other is that, in the end, this new shock will slow down the global economy and take care of inflation.
The shock can hit economic activity through several channels. Rising fuel prices erode disposable income and therefore hold down prices. Falling stock markets have an impact called “wealth effect” – that is, the wealth of consumers falls and they spend less. Risk aversion itself slows down the economy.
None of this prevents gasoline from rising at the pump. But the shock originating in Ukraine could be an additional force to cool the economy in a year in which the U.S. fiscal policy is contractionary. If this movement restrains wage inflation, monetary policy may be less required.
None of this, however, changes the fact that very high inflation in the United States gets a new boost, prolonging the period of high prices. In Brazil, this usually causes great damage to inflation expectations, but for the Fed this is still a question mark. If the Fed looks at activity, it will certainly be taking more risks on the inflation side.
Source: Valor International