Download But, there is no inflation problem

Brazilian Central Bank Panicking on
Inflation
“But, there is no inflation problem”
By Alfredo Coutino, Senior Economist, Latin America
Moody’s Economy.com. West Chester, PA, USA.
April 18, 2008.
Contrary to what we expected, the Central Bank of Brazil tightened
monetary policy in April, in an effort to control the deterioration of
expectations in light of a gradual inflation rebound in the year.
Inflation has shown a mild increasing trend, but it still stays around
the target and far below the upper limit. However, the market was
clamoring for a hike since they expect a continuous inflation rebound
in coming months, thus the central bank acted more to accommodate
market pressures. Hence, the monetary policy committee decided to
raise the benchmark Selic rate by 50 basis points to 11.75% on April
16, interrupting the six-month pause which started last October after a
two-year relaxation cycle. The bank also left the door open for
additional rate hikes during the year.
Certainly, in the past few months inflation has shown a mild increasing
trend, coming from 4.5% last December to only 4.7% in March. The
inflation rebound is practically insignificant, particularly because
inflation is still around the inflation target of 4.5%. This fact, by itself,
does not justify the central bank’s tightening decision, because
inflation is still far below the upper limit established at 6.5%. There
are two more reasons to believe the central bank precipitated in its
decision.
Well-Behaved Inflation
CPI, annual %
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
Inflation
Source: IBGE
Upper limit
Central
target
Lower limit
07
08
On one hand, economic growth continues to advance supported by a
solid domestic market and favorable external demand for
commodities. Even though monetary conditions are restrictive, the
economy continues to expand at solid rates, thus allowing the national
production to match the advance of demand. Indeed, the domestic
absorption in real terms is still lower than the national production.
Under these circumstances no excess demand has been generated and
consequently inflation is not a demand-driven problem, which
introduces doubts about the bank’s action.
On the other hand, monetary conditions were already in the restrictive
zone, since the nominal Selic rate was far above the neutral rate
estimated at 9.00%. With the recent move, the rate is even more
restrictive of economic activity. In fact, the real interest rate has
increased to 7.0%, one of the highest and most attractive rates among
emerging markets. Even more, since rates in the U.S. have decreased,
the yield gap has increased to 9.50 basis points and is expected to
continue widen, thus keeping the attractiveness of Brazilian bonds to
foreign investors. This, obviously, is going to impose more revaluation
pressures on the Brazilian real, which at the end might have a positive
effect on inflation, but it will also impose the risk of external balance
deterioration later.
Restrictive Monetary Conditions
Monetary policy rate (Selic), anual %
14.0
13.5
13.0
12.5
12.0
11.5
11.0
10.5
10.0
9.5
9.0
8.5
8.0
Selic
Restrictive
Zone
Neutral
Zone
Source: Banco Central do Brasil
07
08
In fact, since there is no real inflation problem in Brazil and monetary
conditions were already restrictive, the central bank's move seems to
be in the wrong direction. Thus, the central bank’s panic is mainly
explained by the recent reduction of the exchange rate gains on
inflation. In this regard, the justification could be the fact that the
central bank is mostly interested in keeping the currency revaluating
for whatever reason.
Monetary tightening is only effective if inflation is driven by demand
factors, which is not the case of Brazil. The economy does not suffer of
an excess demand; on the contrary, it has an excess supply. In this
regard, the interest rate hike is not going to be effective to fight
inflation but only to restrict economic activity more, which could
induce a more remarkable deceleration of growth in coming months.
Under the expected environment of global slowdown, if authorities
want the economy to grow at its natural rate, monetary conditions
should resume the relaxation cycle and move the rate to the neutral
zone. In the end, more flexible monetary conditions will be needed this
year to strengthen the domestic absorption, which will let the economy
to mitigate the negative impacts of the U.S. recession. Thus, the
strength of the domestic market will contribute to compensate for the
moderation of the external demand. But also, lower interest rates will
help reduce the currency revaluation and move the Brazilian real to a
more competitive position. This will allow the country to keep the
pressure of domestic demand stimulating the national production
instead of letting it escape to the outside through more imports.
This commentary is produced by Moody's Economy.com, Inc. (MEDC), a subsidiary
of Moody's Corporation (MCO) engaged in economic research and analysis. MEDC's
commentary is independent and does not reflect the opinions of Moody's Investors
Service, Inc., the credit ratings agency which is also a subsidiary of MCO.
Moody's Economy.com (MEDC) is a subsidiary of Moody's Corporation, and is
headquartered in West Chester, Pennsylvania. MEDC is a leading independent
provider of economic, financial, country, and industry research.
Copyright © 2008 Moody's Economy.com, Inc.
Moody's Economy.com, 121 North Walnut Street, Suite 500, West Chester, PA 19380-3166