High employment levels benefit economic activity and may boost growth but pressure inflation and could impact the intensity of interest rate cuts

04/26/2024

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Leonardo Porto — Foto: Leonardo Rodrigues/Valor

The unexpectedly robust job market performance has surprised economists and is good news for economic activity. However, it is also a major concern for the Central Bank. While a heated job market reflects a buoyant economy and means more income and consumption, a tight labor market can generate greater inflationary pressures and slow the pace of interest rate cuts, economists say.

Despite other factors, such as changes in fiscal targets and monetary policy directions in the United States, adding pressure to the decisions of the Monetary Policy Committee (COPOM), low unemployment and rising income continue to pose a problem for the Central Bank in reducing the Selic key interest rate.

In a report sent to clients recently, Citi Brazil noted that the current unemployment rate of 7.6%—the lowest since the first quarter of 2015—and real wage growth indicate the restrictive nature of labor market conditions in the country.

“The already tight labor market conditions, coupled with the view that growth is heading for acceleration, are likely to increasingly restrict the disinflation process,” wrote economists Leonardo Porto, Paulo Lopes, and Thais Ortega. “This outlook will likely motivate the COPOM to halt the interest rate reduction cycle not only sooner but also at a higher level.”

In particular, the pace of wage increases is not in line with productivity, said Mr. Porto, chief economist at Citi Brazil. “If wages rise in line with productivity, it does not generate inflationary pressures. However, if this increase is not anchored, there are potential risks of inflationary pressures emerging,” he added.

“When we look at data from the National Household Sample Survey (PNAD), we see a nominal wage increase of 9% and a real increase of 4.3%. These numbers are well above any productivity estimate in Brazil.”

A warning, the economist notes, is the sign of economic acceleration, which should further heat the job market.

After stagnation in the second half of 2023, Citi estimates GDP growth of 0.4% in the first quarter and 0.6% in the second, compared to the previous quarter, driven by domestic demand, particularly from household consumption and investment. For the year, the bank expects GDP growth of 1.5%. The unemployment rate, meanwhile, should stand at 7.5% this year, compared to 8% in 2023.

“In these conditions, the labor market is expected to strengthen even further in the future, with lower unemployment rates, pointing to an even smaller output gap [the difference between current GDP and potential GDP],” the report said.

These risks are added to a scenario of unanchored disinflation expectations in the medium and long term, which creates an additional limitation for the Central Bank.

In the Focus survey released on Tuesday, the inflation expectation for 2024 rose to 3.73% from 3.71% in one week. For 2025, the projection increased to 3.60% from 3.56%.

In addition to sustaining high service inflation, the tight job market is expected to lead to higher goods inflation, according to Citi. The bank projects a 4% rise in the benchmark inflation index (IPCA) this year.

Mr. Porto expects a Selic cut to 10% at the COPOM meeting in June. However, there are doubts about whether this projection should be recalibrated. This is because, in recent days, other risks to the interest rate cut cycle have begun to materialize.

Domestically, the change in the fiscal target has raised an alert. Internationally, there have been shifts in U.S. monetary policy, with the Federal Reserve facing greater inflationary pressures—in March, the consumer price index CPI advanced 3.5% on an annual basis, against an expectation of 3.4%.

As a result, there has been a repricing of U.S. monetary policy, said Rodolfo Margato, an economist at XP. At the beginning of the year, the market had priced in at least six interest rate cuts over the year. Now, there is uncertainty about the next cut, and the market also sees a 20% chance of an interest rate hike at the next Fed meeting at the end of April.

Discounting external pressures, domestically, Mr. Margato said, the dynamics of the job market continue to be one of the main variables monitored by the Central Bank.

“Since the third quarter of last year, the main indicators of the job market in the PNAD and the General Register of Employed and Unemployed Workers (CAGED) have been surprisingly high. The employed population grows consecutively, with emphasis on formal employment since the beginning of 2024,” he said.

“From a monetary policy perspective, the main factor to be monitored is the dynamics of real wages. The PNAD shows real average income from work on an upward trajectory since September. Data from CAGED and the Salariômetro [Salarymeter, in a free translation] from the Economic Research Institute Foundation (FIPE), are moving in the same direction.”

XP expects the average income (received from all jobs) to grow 2.5% in real terms this year, compared to 2023.

This positive moment, he said, is due to a combination of three variables. First, the traction of economic activity in recent months, which should reflect a 0.7% GDP increase in the first quarter, according to XP. The second is the increase in the minimum wage, which saw real growth of 3%.

“The third, which generates discussion among analysts, is the equilibrium unemployment rate, called NAIRU, which does not accelerate inflation. In our discussions, NAIRU would be around 8%, but we have already begun to observe it below 8% in the third quarter of 2023,” said Mr. Margato. “With it below that level, there may be pressure on wages and acceleration of inflation.”

The Central Bank has been closely monitoring some groups of the IPCA, he said. One would be services inflation, which is expected to grow 4.5% this year compared to 2023, according to XP. The underlying IPCA for services, a kind of core inflation for services, which excludes volatile items such as airline tickets, is expected to advance 4.9%. The IPCA for labor-intensive services, in turn, is expected to rise 5.2%. All projections are well above the Central Bank’s inflation target for this year, of 3%.

XP expects an IPCA of 3.5% for 2024, with an upward bias that could take the index to 3.7%. The projection for the Selic, at 9% by the end of this year, is under review.

“There are still many uncertainties, which the COPOM has highlighted when referring to the domestic scope. In the case of the labor market, we see signs of moderation in the short term, but they are insufficient for service inflation to converge to the target,” said Mr. Margato.

In its latest statement, on March 20, the COPOM highlighted an environment marked by pressures in the labor markets of emerging countries, which requires “caution.”

A report by consultancy MB Associados observes that the statement emphasizes uncertainty mixed with the resilience of activity and the labor market.

“The [Central] bank signaled another 50-basis-point cut, to 10.25% [per year] in May, but leaving some room for maneuver. The possibility of a softer 25bp cut exists, without affecting the end-of-cycle rate. By suggesting that the cut could be softer, the Central Bank demonstrates a concern with some inflation items that remain very pressured,” wrote Sérgio Vale, an economist at consultancy MB.

“It will be difficult for the Central Bank to justify further interest rate cuts given the strong expansion of employment, income, high employment rate, and low unemployment,” said Mr. Vale, who expects an unemployment rate of 7.5% this year and greater heating of the job market in response to economic activity.

In the report, MB states that elements of uncertainty will likely cause the Central Bank to end the Selic rate cut cycle at 9.25%, and “those who imagined a much lower Selic may have to revise their projections.”

This interruption, said Mr. Vale, could be the harbinger of a much more tumultuous second half in terms of monetary policy—besides the end of the interest rate cut cycle, the terms of the Central Bank president and two directors will end soon.

“In the second half, the debate will be about which Central Bank we will have and where we are heading,” he added.

*Por Marsílea Gombata — São Paulo

Source: Valor International

https://valorinternational.globo.com/