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Analysis: Inflation expectations worsen again days before meeting

Projections for the shorter term continue to deteriorate, driven in large part by the prospect of higher fuel prices

01/30/2023

Central Bank’s building in Brasília — Foto: Jorge William/Agência O Globo

Central Bank’s building in Brasília — Foto: Jorge William/Agência O Globo

Inflation expectations in the financial market have deteriorated again just days before the meeting of the Central Bank’s Monetary Policy Committee (Copom), which will unveil its decision on Wednesday.

The trend of deteriorating inflation projections for shorter terms continues, mainly driven by the prospect of higher fuel prices. In longer terms, fiscal uncertainty and the noises generated by President Luiz Inácio Lula da Silva’s remarks on a possible revision of inflation targets are weighing.

In one week, the measured forecast by economic analysts for inflation in 2023 rose to 5.74% from 5.48%. Part of the increase is due to the likely end of the federal gasoline tax holiday in March. The reopening of China’s economy also tends to put more pressure on oil prices. The forecast for regulated prices rose to 8.39% from 7.25%.

However, this deterioration in short-term inflation, however, is unlikely to have a significant impact on the conduct of monetary policy. From this meeting on, the Copom will focus mainly on the 2024 inflation target. Policymakers have stated that they are focusing on inflation six quarters ahead, that is, inflation up to September 2024. By then, most of the pressure on regulated prices is likely to have dissipated.

The point is that inflation expectations for 2024 are also deteriorating. During the week, they went to 3.9% from 3.84%. At the last Copom meeting in December, it was 3.5%, already above the target of 3% for the year.

This worsening of expectations in the so-called relevant horizon for monetary policy – in other words, the period in which the Central Bank proposes to achieve the target – creates an additional constraint for the conduct of monetary policy. But one must not exaggerate. The Central Bank’s decisions are based on policymakers’ projections. The Central Bank usually reacts with further monetary tightening if its projections show a statistically relevant deviation from the target.

It is very likely that the monetary authority will keep its own estimates below the market. In December, the Copom projected inflation at 3% for 2024, below the market’s estimate of 3.5%.

The deterioration in market inflation expectations is expected to weigh on the Central Bank’s own projections. On the other hand, the Central Bank asked for market estimates of the expected fiscal expansion in 2023. According to the December survey, public spending is expected to increase by R$140 billion above the cap.

The Central Bank, on the other hand, does not have many additional reasons to raise its inflation projections for 2023, since its scenario already includes the expiration of the tax cuts. As a result, one should not expect much more inflationary inertia in 2024.

But there are factors that point in the opposite direction: the exchange rate has appreciated since December. In addition, the interest rate level used in the Central Bank’s forecasting model is likely to be much higher.

The Central Bank feeds its projections with market expectations for the Selic, which is Brazil’s key interest rate. In December, the start of the reduction cycle was expected for August. Now, for November.

In other words, thanks to the exchange rate and the monetary tightening that occurs within the model itself, even with the short-term Selic at current levels, the Copom may be able to present a somewhat stable inflation projection for 2024.

One should also keep in mind that the Central Bank looks carefully at other factors in making its decision. There is a component that looks backward, not just forward. The Copom has been looking carefully at the evolution of services inflation and the economic slack.

The question is how the Central Bank will deal with the deterioration in the market’s perception of fiscal risk and the risk of a change in the inflation targets, which has raised the experts’ longer-term projections. The median projection for 2025 was unchanged at 3.5% last week, and expectations for 2026 rose to 3.5% from 3.47%. At the December meeting, they were close to 3%.

Strictly speaking, these years are too far away to affect the most immediate conduct of monetary policy. But they are a very strong warning about fiscal risks. If the Central Bank were to say that fiscal risks to inflation predominate, this would theoretically require more action on interest rates.

But that seems unlikely, at least in the short term. The Central Bank has advocated calm in its assessment of fiscal risks, so one should not expect a clear warning. As for President Lula’s remarks about a possible change in inflation targets, Central Bank President Roberto Campos Neto tried to pour oil on troubled waters by saying that there were distortions in relation to what was said.

Moreover, fiscal risk is not the only news lately. The exchange rate has fallen, despite all the market fears about the public accounts, due to a more favorable international scenario than expected. The reopening of China is boosting commodity prices, and the scenario for activity and inflation in the developed world seems less gloomy.

In the past, under Ilan Goldfajn, the Central Bank liked to see the fiscal risk in its international context. The message at the time was that what was really worrying was the combination of fiscal risks with the international environment for emerging markets.

*By Alex Ribeiro — São Paulo

https://valorinternational.globo.com/
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Analysis: First good news on inflation expectations

According to Central Bank’s Focus survey, it retreated to 3.47% from 3.5%

10/11/2022

Brazilian Central Bank — Foto: Michel Filho/Agência O Globo

Brazilian Central Bank — Foto: Michel Filho/Agência O Globo

Inflation expectations for 2024, a year increasingly important in monetary policy decisions, receded a bit last week, to 3.47% from 3.5%, in Focus, Central Bank’s weekly survey with economists. The percentage is still above the target set for the year, of 3%, but this is the first good news for the conduct of monetary policy in a long time.

Until now, what had been falling were basically inflation expectations for this year and next, which are very much influenced by the pricing policies adopted by the government during the elections, such as tax cuts on fuel and other essential products.

But inflation expectations for 2024 had been worsening, in a sign that market analysts believe the measures bring only illusory gains because they amplify the fiscal risk and are likely to be reversed in the medium and long term.

The drop in expectations comes after the Monetary Policy Committee (Copom) toughened its message about interest rates, hinting at the maintenance of the key interest rate Selic at the current 13.75% per year for a long time and indicating that, if necessary, it may resume hikes.

As the drop in inflation expectations this week was quite small, for the time being, it can be understood more as stabilization of inflation projections, after rising a lot, and not as a new downward trend.

In its September meeting, the Copom came to the conclusion that although the median (the most central percentage among all the projections informed by the specialists) of inflation expectations was worsening, the average (sum of the projections informed, divided by the number of projections) remained stable.

“The median of inflation expectations for 2024 rose since the previous Copom meeting, even though the average has been more stable,” said the minutes of that meeting, released two weeks ago.

The average is considered to be a leading indicator of what happens to the median. In recent weeks, the average has remained stable, a little below the median. But, for the time being, it has not retreated. It remained at 3.48% last week.

Another leading indicator is the median of expectations informed by specialists in the last five working days. They have been oscillating between 3.5% and 3.3% in recent weeks. The official indicator for expectations is the median of expectations informed by specialists in the last 30 days.

Another good news is the decline in expectations for service inflation in 2024. During the week, it was lowered to 3.7% from 3.8%. It will be necessary to watch the data in the coming weeks to see if, in fact, economic analysts are more confident that the current monetary tightening will cool down the economy and cause service inflation to fall.

*By Alex Ribeiro — São Paulo

https://valorinternational.globo.com/
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Bets on key interest rate at 14% gain ground

Most agents expect 50-basis-point hike this week

08/01/2022

Central Bank's headquarters in Brasília — Foto: Jorge William/Agência O Globo

Central Bank’s headquarters in Brasília — Foto: Jorge William/Agência O Globo

The current monetary tightening cycle, now entering its 18th month, may be nearing its end. After a 1,125-basis-points hike in the key interest rate Selic and Central Bank’s messages that the magnitude of the tightening matters, most of market participants believes that the Monetary Policy Committee (Copom) will deliver one final 50-basis-points hike this week, to 13.75% a year. This view, however, is far from being consensual and, with the strong deterioration in medium-term inflation expectations, a relevant portion of the agents expects the rate to reach at least 14% this year.

A survey carried out by Valor between July 27 and 29 shows that medium-term inflation expectations continued to rise. The average point of the 110 estimates collected for the IPCA (Brazil’s official inflation index) in 2023 was 5.4%, well above the top of next year’s inflation target range (4.75%). In addition, agents are already concerned about the de-anchoring of expectations at longer horizons. The median of 86 projections points to an IPCA of 3.5% at the end of 2024, compared with the center of the target of 3%.

In this environment, which includes an already advanced stage of the tightening cycle and still very negative conditions for current and prospective inflation, there is a clear division among market participants regarding the next steps of monetary policy. It is worth pointing out that in this week’s decision, the relevant horizon for the Copom’s actions is expected to include the calendar year 2023 and, to a lesser extent, 2024.

Thus, even though the expectation of a 50 bp increase in the Selic this week is virtually consensual, the perspective for the rate at the end of the year still causes a significant division among market economists. Valor’s survey shows that 65 analysts expect the key interest rate to reach 13.75% this week and to remain at this level; 32 see the Selic at 14% in December; and 17 project a rate of 14.25% at the end of the year.

“Although there is indeed some possibility that the Copom will choose to interrupt its monetary tightening cycle, especially given the significant extension and intensity [of hikes], we do not believe this will happen in August,” says José Maurício Pimentel, the chief economist at BB Asset. The prospective inflationary picture and the risks around expectations are not yet “safe enough” for the Central Bank to end or even pause the cycle, he says.

“The level of current inflation and its core and diffusion indexes have not yet eased substantially. The recent drop in commodity prices in the international market may help but they could rise again in view of potential new supply problems,” Mr. Pimentel says. BB Asset expects the cycle to end only in September, with the Selic at 14.25%.

By simulating Central Bank’s inflation models, Anna Reis, chief economist and partner at Gap Asset, estimates that the monetary authority’s new projection for inflation at the end of 2023 is expected to rise to nearly 4.3%, compared with 4% in June’s decision, thanks especially to the adjustment of some taxes foreseen for 2023. As a result, the Central Bank’s inflation estimate would move even further away from “around the target” – a strategy the Copom revealed in its last decision that it has been pursuing. In Mr. Reis’s view, this would justify a new adjustment in interest rates in September.

“Reproducing the mechanics it [the Central Bank] has been using, we still think that the conclusion will be that some additional tightening will be necessary. Given the already very high level of the Selic rate, it may signal a new, smaller increase or even leave the door completely open, in the sense of not increasing it further,” he says. Besides the 50 bp increase this week, the economist works with a final 25 bp increase in September, when he sees the Copom ending the tightening cycle.

Although he expects a residual adjustment in September, Mr. Reis believes that the level of interest rates in the Brazilian economy is already quite contractionary, with a real ex-ante rate around 8.3%, a level similar to that of the 2015 monetary tightening cycle.

In addition, the economist believes that the 2023 inflation projections are contaminated by the shocks affecting current inflation. “It’s three consecutive years of expressive shocks that have taken Brazilian and global inflation to high levels, and economists tend to extrapolate the scenario forward. We believe that the risk of inflation in 2023 is greater to be down than up,” he says. Gap projects the IPCA at 5% in 2023 and at 3% in 2024.

Gustavo Arruda, the head of research for Latin America at BNP Paribas, says that the role of the Central Bank, at this moment, is to contain the problem. “The de-anchoring of expectations has happened and we are seeing higher numbers, above 5%. The de-anchoring of expectations is increasing, not decreasing. If I don’t know what is going to happen with the inflationary scenario, one has to work with the balance of risks. And, within this environment, I would rather have the risk of doing more than less, even though it is more costly in terms of activity,” Mr. Arruda says.

BNP Paribas was one of the first banks to point to a scenario of a Selic rate around 14% – and it is still the bank’s baseline scenario. “I can’t see the Central Bank stopping at this point. We know that inflation in the short term will fall for reasons unrelated to monetary policy, but next year’s expectations are rising, as are those for 2024,” he says.

“And, as for the news, we know that there will be more public spending, which is likely to boost demand at the margin. The Central Bank expected that monetary policy would start to decelerate growth starting in the third quarter, but a considerable part will be counterbalanced by fiscal policy,” Mr. Arruda says. In his view, if the Central Bank ends the cycle at this point, it risks facing even higher expectations ahead.

Anxiety surrounding the Copom’s communication regarding the next steps in monetary policy has increased since the committee is used to indicating what it foresees for its next decision. With the cycle nearing its end, the market must therefore remain very attentive to the signals from the policymakers to calibrate bets regarding the end of the cycle.

Economists at Itaú Unibanco expect the Copom to signal that the most probable scenario is the end of the cycle, but leaving the door open for a possible final hike in key interest rates in September should the inflationary scenario deteriorate further. “Additionally, we believe that the monetary authority is likely to determine that an eventual additional adjustment would be implemented at a slower pace (25 basis points),” say the economists at Itaú, which projects the Selic at 13.75% per year at the end of the cycle.

The chief economist for Brazil at HSBC, Ana Madeira, believes that the Copom is likely to try and give “as little information as possible” and present few changes in relation to the announcement of June’s decision, by maintaining a tone more dependent on the evolution of indicators. “I also expect the Central Bank to leave itself some room to reduce the pace in the next meeting,” she says.

According to the economist, the recent deterioration in inflation expectations is expected to force the Copom to deliver another residual 25 bp hike in September. She believes that only next month will the slowdown in economic activity start to show clearer signs and open space for the monetary authority to put an end to the tightening cycle.

Ms. Madeira also estimates that the continued normalization of supply shocks next year and a synchronized slowdown in the global economy are likely to cause faster disinflation in the economy – HSBC has a projection of 4% for the IPCA in 2023. “In April, the IPCA is expected to already be around 6%. This will mean that we will start to see inflation slowing down, and this will leave room for the Central Bank to start the cycle of interest rate cuts,” says the economist, who estimates the Selic at 9.75% per year in 2023.

On Friday, the yield curve was pricing a Selic around 14% per year by the end of the year and between 12.25% and 12.5% in 2023. The Copom options market, on the B3, pointed to an 88% probability of a 50 bp hike in the Selic this week against an 11% chance of a 25 bp hike. In relation to the Copom’s September meeting, the market pointed to a 35% chance of stability, a 40% chance of a 25 bp hike and a 21% chance of a 50 bp increase.

Garde Asset’s baseline scenario includes 50 bp hikes in August and September, to 14.25%. “We believe that the Central Bank will take into account the additional de-anchoring of expectations. It is concerned about that and will have to react to that,” says Garde’s chief economist Daniel Weeks.

“The focus is going to be on how the Copom will signal the next steps. And, given the deterioration of the prospective inflation scenario between meetings and the fiscal deterioration, both due to the higher risk and the increase in disposable income, it is very difficult for the Copom to close the door and say that it will stop raising interest rates,” he says. In Mr. Weeks’s view, the Central Bank will leave the door open to raise the Selic rate by the same magnitude – 50 bp – or at a slower pace in September.

*By Gabriel Roca, Victor Rezende — São Paulo

Source: Valor International

https://valorinternational.globo.com/
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