The international environment is emerging as a source of concern for Brazil’s efforts to control inflation in the short and medium term. In particular, economists are increasingly focused on growing threats related to oil prices and U.S. monetary policy.

These factors add to an already extensive list of domestic risks on the radar, including the impact of El Niño on food prices, the potential effects of ending the six-day workweek with one day off (known as the 6×1 schedule) on labor costs, tax reform, and the new basket of goods and services monitored by the Extended Consumer Price Index (IPCA). The basket is expected to change with the next edition of the Household Budget Survey (POF), due out at the end of this year.

Brent crude prices have returned to around $115 a barrel amid growing indications that the conflict between the United States and Iran could escalate again. President Donald Trump has signaled that he intends to pursue a short-term military campaign after the U.S. midterm elections, which begin in less than a week. Meanwhile, Israeli Prime Minister Benjamin Netanyahu, who faces a political test in elections in Israel this week, has renewed nuclear threats against neighboring Iran.

In Brazil, the impact of these shocks has been cushioned by the government’s subsidy and support programs. “The question is whether, if this conflict persists, the government will be able to maintain this policy for long given its fiscal cost. Otherwise, it would have to let prices rise, which would affect inflation,” said Julio Cesar Barros, an economist at Daycoval. His calculations show that removing the subsidies would add 0.4 to 0.5 percentage points to the IPCA.

In Buysidebrazil’s baseline scenario, which projects the IPCA at close to 4.7% in 2027, the average oil price that year is expected to fall to $85 a barrel as risks in the Middle East subside. If the reversal is less pronounced, however, the inflation estimate would be higher. A return to $100 a barrel could add 0.4 percentage points to next year’s projection, while a decline to $110 would add another 0.6 percentage points, said the consultancy’s chief economist, Andréa Damico.

“The balance of risks for the IPCA is extremely skewed to the upside. Previously, there were some disinflationary factors, such as a lower risk premium and a stronger exchange rate in the event of an opposition victory in Brazil, that could have offset all the upside risks, including El Niño and the end of the 6×1 work schedule. Now, we no longer have those counterweights,” the economist noted.

In a recent study, XP Investimentos estimates that fuel subsidies and support measures could remain in place for longer, since at oil prices above $105 a barrel, their net fiscal cost is positive.

“However, even at this price level, gasoline prices would still face some upward pressure, requiring a degree of adjustment and potentially adding up to 0.15 percentage points to the IPCA if Petrobras implements a partial price increase. Therefore, fiscal balance alone does not guarantee that current fuel prices can be maintained,” noted Basiliki Litvac and Rodolfo Margato, the study’s authors.

In its baseline scenario, however, the firm expects oil prices to average $75 a barrel in 2027, which would allow the government to phase out these policies. “Since subsidies have been mitigating the increase in prices, their removal would be gradual,” Litvac argued.

She and Margato stressed that crude oil prices are not the only factor that needs to be considered at this point. Another is the so-called crack spread, or the difference between the price of the commodity and the market value of refined products such as gasoline and diesel. This indicator—a proxy for refinery profit margins—remains well above the levels seen over the past five years.

In simulations using different oil prices and crack spreads, the economists found that, at current levels ($115 a barrel), removing the tax exemption on gasoline could have an upside impact of between 0.05 and 0.74 percentage points on the IPCA, depending on prevailing refining margins. If oil prices return to $85 a barrel, the increase would range from zero to 0.22 percentage points.

A return to $75 a barrel, therefore, would allow the government to reverse subsidies and tax breaks while narrowing the gap between domestic and international prices without passing the increase on to consumers. “However, we recognize that risks remain to this more favorable oil price trajectory, creating an upside bias in our inflation forecast,” they wrote in the XP study.

As for U.S. monetary policy, the risk is that higher interest rates in the United States will strengthen the dollar and lead to exchange-rate pass-through in Brazil. “I no longer see the kind of dollar weakness that did so much to help domestic inflation,” said Solange Srour, UBS GWM’s head of Brazil macroeconomics. “The U.S. economy is holding up well, and unemployment remains low. The market believes the Fed will raise interest rates in December, and the latest inflation figures came in higher than expected. So the risk here is a weaker exchange rate.” In her view, “even if some fiscal adjustment is announced, the expected benefit of a stronger currency resulting from a change in the administration will not materialize.”

In XP’s exchange-rate model, the three most important factors are Federal Reserve policy, fiscal risks, and commodity prices. On the latter, Margato noted that price movements have been supportive of the real. The Brazilian currency had the third-best performance among emerging-market currencies through the second round of Brazil’s election and, even after depreciating by approximately 7% following President Luiz Inácio Lula da Silva’s victory, has continued to track the group average.

“The fact is that Brazil is a commodity exporter, and our terms of trade have improved significantly. The balance of payments is an important underlying strength. Estimates for both the trade surplus and foreign direct investment in Brazil have been revised upward. This is an important source of support for the exchange rate, even during periods of heightened domestic risk,” he noted.

Regarding the other two factors, the economist acknowledges the possibility of greater pressure in the opposite direction. “Interest rates appear to pose the greater risk. At the short end of the curve, rates respond to the possibility that the Fed may need to tighten policy further because economic activity remains strong and inflation persistently above 2%. The belly and long end of the curve, meanwhile, reflect growing concerns about fiscal risk, which is also something we will be discussing extensively in Brazil over the next few years.”

XP estimates that the average exchange rate in 2027 will be around R$5.30 to the dollar. However, in a simulation of a more severe stress scenario for the U.S. dollar, the exchange rate in Brazil could reach R$5.65. In that case, exchange-rate pass-through would add 0.45 percentage points to the IPCA over 12 months.

Barros, of Daycoval, noted that the wide spread between Brazil and the United States supports the exchange rate, even after adjusting for risk. “An exercise we conducted shows that only when this risk-adjusted spread falls below 3.9% do interest-rate changes amplify the exchange rate’s response. And given the rate cuts priced in for Brazil and the hikes expected in the U.S., we still have some room to absorb those moves. That threshold will only be crossed at the end of 2027,” he said.

He noted that the greater risk lies in the Fed accelerating its rate hikes. In Brazil, although the possibility of faster rate cuts cannot be ruled out, the expectation is that the Central Bank will maintain its pace of 0.25 percentage points per meeting. “From an economic activity standpoint, a slowdown is underway, but we have assigned less weight to the risk of a recession because of some fiscal stimulus measures recently approved. On the inflation side, there are supply-side shock challenges that could push prices higher,” he said.

*By Marcelo Osakabe — São Paulo

Source: Valor International

https://valorinternational.globo.com/