Thomas Wu — Foto: Silvia Zamboni/Valor

The strategy by the Brazilian Central Bank that prioritizes keeping the Selic at a level around 13% for longer instead of raising the benchmark interest rate to even tighter levels is valid. Thomas Wu, the chief economist at Itaú Asset, believes that it is preferable that monetary policy “be a marathon, not a 100-meter dash,” considering the current interest rate.

In line with the market, Mr. Wu projects a hike of 100 basis points in the Selic rate in Wednesday’s Monetary Policy Committee (Copom) announcement, and another one of 50 basis points in June, taking the rate to 13.25% at the end of the cycle. “Maybe it can go up in August, but 50 basis points more will not change the entire strategy. The Central Bank is very close to stopping,” said the economist, who has already worked at Verde Asset and was a professor at the University of California, Santa Cruz.

In an interview with Valor, his first since he joined Itaú Asset in January, Mr. Wu points out that raising interest rates to a much more restrictive level may not be advantageous to bring inflation to the target in 2023 if this hinders the more general notion of well-being that it ultimately should represent. “What it [the Central Bank] needs to make very clear is that it will only cut interest rates when inflation starts to fall,” Mr. Wu said, acknowledging that the choice “for consistency” brings challenges. Read the interview below.

Valor: The Central Bank started to indicate in March that it wants to end the cycle of interest rate hikes. How do you see this strategy?

Thomas Wu: Any problem has three variables: its size, the dose of the medicine and the duration of the treatment. The interest rate is already restrictive, our neutral rate is not at double-digit levels, although the way we estimate the neutral real interest rate is somewhat vague. If we look at the 360-day nominal interest rate and subtract the 12-month inflation expectation showed by the Central Bank’s Focus bulletin and the neutral rate estimated by the monetary authority, we have tightening similar to that of 2015 and 2016. How big is the problem? Each month we find that the gap between inflation and the target is wider. The Central Bank, then, could set a fixed relevant horizon and, if it finds that the problem is bigger, increase the dose of the medicine and go to [a Selic of] 14%, 15%, 16%. Or, as a central bank, it also has the right to do something else. If it suspects that the dose of the medicine is starting to cause more side effects, it can think that it has already reached the size and extend the horizon. It will get there, but will take longer.

Valor: Is the Central Bank close, then, to ending the cycle?

Mr. Wu: As a strategy, the Central Bank is very close to ending. He may give 100 basis points next time and maybe 50 basis points in June. Maybe it can go up in August, but 50 basis points more will not change the entire strategy. In the estimation of models, the interest rate is already in the contractionary territory. It must make very clear that it will only cut interest rates when inflation starts to fall. It is a strategy for consistency, which does not raise the dose of medicine up high. Roughly speaking, I think it is valid, although it has its challenges. It is not easy.

Valor: What are these challenges?

Mr. Wu: To stop raising interest rates while underlying inflation is still on the rise. The statement has to be very well done and has to say that it is stopping [raising the Selic], but not because it is abandoning it. The risk of this strategy is that some people interpret that the Central Bank is not doing what it needs to do and that expectations become even more unanchored.

Valor: Inflation expectations for 2023 are already quite far away from the center of the target…

Mr. Wu: We are working with inflation above the target next year. We have 8.1% this year and 4.6% in 2023. Does this mean that we think the Central Bank will not do its job? Not at all. Inflation is a global problem. Inflation is high and accelerating around the world, and Brazil is one of the few countries where interest rates are in the contractionary territory. I don’t project inflation at the target next year because I don’t think it is necessary to put the interest rate at such a level that convergence happens in 2023. In my estimates, the rate needed for that would do more harm than good. You would anchor inflation, you would bring it to the target, but the target, in a general context, indicates more sustainable long-term growth. If you take this literally and raise interest rates to bring inflation to the target next year, maybe this more general concept of sustainable growth starts to lag further behind.

Valor: When would this convergence occur?

Mr. Wu: We have had several shocks around the world. Interest rates tackle the secondary effects. I think we are going to live for a long period with high inflation and above the target. It will take a long time for interest rates to drop. We are discussing some convergence in 2024. It is a matter of preference. Some economists will say that, unfortunately, for reasons of anchoring and credibility, there is no other way out than to take interest rates to 15%, 20%… This is also valid. I prefer it to be a marathon, not a 100-meter dash. It’s about persevering with an already contractionary dose of medicine, resisting all the pressures to cut and only start reducing interest rates when it is clear that the problem has been addressed. Starting an easing cycle at the end of next year is risky. The market has already priced it in at the turn of the year. I think it is a quite optimistic assumption, especially because we don’t know yet how big is the problem.

Valor: Major central banks around the world are also beginning to tighten their monetary policies. Doesn’t this help to contain some of this global inflation?

Mr. Wu: All central banks except Japan are saying that they are going to start doing some kind of monetary tightening, each one at a different timing of its cycle. Is a recession coming? I think it will come in the same way that we are sure that winter will come. It doesn’t mean that I am super pessimistic. But you can’t fight inflation without holding back aggregate demand. At the moment, the biggest problem is that inflation is still accelerating. A great part of it has to do with a very strong demand in the United States.

Valor: What is the asset manager’s projection for U.S. interest rates?

Mr. Wu: This terminal rate around 3% that appeared in the last FOMC meeting seems low to me. For a terminal rate to be in the contractionary territory in the U.S., the risk is for it to be above 4%.

Valor: And here in Brazil, do you see evidence of demand inflation?

Mr. Wu: We have a very high diffusion. The number of products at a high inflation rate is large, it goes beyond food. When you see something like that, you imagine it has a common demand component. Interest rates are at a contractionary level, consumer default rates are rising, but consumer spending is strong and I think it will take time to disinflate. As for the labor market, it is not wonderful, but it is resilient, it is not weakening.

Valor: Isn’t the interest rate tightening having any effect?

Mr. Wu: Like the whole market, we have been surprised by the strength of consumer spending. The question we asked ourselves was: Isn’t the interest rate in the contractionary territory? Or is the effect more delayed than usual? We concluded that it [the higher interest rate] will take longer to impact [the activity]. Corporate results are healthier. At the opposite end, individuals enter this cycle more leveraged – for a good reason, as more people have access to credit. On the other hand, we are experiencing a good moment in terms of how people feel about the pandemic, and there is pent-up demand when people are concerned. The authorization to withdraw money from Workers’ Severance Fund (FGTS) accounts and the anticipation of the 13th salary [a year-end bonus] also help the balance of households. This is why I have the perception that the Central Bank’s strategy to disinflate the economy has to be done with persistence. It will require patience, perseverance, discipline. But we also have to be humble; the moment is one of great uncertainty.

Valor: Is it the effect of this monetary policy ahead that justifies Itaú Asset’s projection for the GDP to go to 0.2% in 2023 from 0.8% in 2022?

Mr. Wu: Yes, with great uncertainty around, but we think that these effects will be greater in 2023. It is going to be a difficult year, because we are already going to feel the tightening of interest rates more strongly in activity, but I don’t know if underlying inflation is already giving clear signs that it is heading towards the target. We have 9.25% [of the Selic for 2023], but with an upward bias.

Valor: The exchange rate has become quite volatile again in the last few days. With which perspective do you work?

Mr. Wu: Looking at the Central Bank’s strategy of a tightening cycle that started in March of last year, to anchor inflation around 2024, the importance of the exchange rate in the model is not necessarily to find out the date of the Copom cut and see how much it gave. The Fed [U.S. Federal Reserve] started to become more hawkish about raising interest rates as of November [2021] and, in general, when a central bank as important as the American one becomes more aggressive, assets that are considered riskier lose value. The exchange rate suffers, but this is not what happened until very recently. It was a surprise, but now we can understand that one of the most relevant changes this year, after all these cyclical issues have passed, is that the world changed structurally at the beginning of 2022 with the conflict [in Ukraine]. Apart from the whole tragic issue, we focus on understanding what really changes with the end of the war and we realize that the relevance of Brazil and Brazilian assets in the world portfolios has increased. Structurally, I think Brazil will see more inflows over the next few years on average. Of course, there is a lot going on right now, like the lockdown in China, the Fed raising interest rates, the conflict. Looking at the end of this year, we had, until last week, more confidence that it would be a trajectory of appreciation [of the real against the dollar]. Now we are discussing four 50-basis point hikes, it is starting to get a little more tense, so there is a risk that this year will be bad, in a structural context in which the importance of Brazil has increased.

Source: Valor International

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