GENERAL APPOINTMENTS
The International Outlook
The current world outlook is uncertain, however within a context of recovery of global economic activity.
There is still uncertainty about the implementation and possible international repercussions of the new US government economic policy.
1. Increased protectionism should impact the global economy and indirectly affect Brazil in the longer run.
2. Further expansionary fiscal policy in the US, an economy close to full employment, may lead to an increase in inflation and to tighter monetary policy.
In other regions, as in Europe, stimulus would more likely boost growth, with smaller needs for monetary policy to respond.
This asymmetry would tend to strengthen the dollar.
Uncertainties aside, both the US and other advanced economies are recovering, in synchronization with several EMEs. This output recovery have helped to sustain higher commodities prices that benefited some EMEs.
We see the sustainability of global output growth momentum and the maintenance of current levels of commodities prices as possible risks.
This global outlook coincides with a period of economic stabilization in the Brazilian economy, and improvement and its fundamentals.
Brazil is now less vulnerable to external shocks.
Summarized Retrospect for the Brazilian economy
The uncertain global outlook coincides with a period of economic stabilization in the Brazilian economy and improvement and its economic fundamentals.
Since 2011, Brazil has suffered a setback comparable to an adverse supply shock, which produced the most severe recession of its history, combined with high inflation.
A change of government and a new direction for economic policy reversed the previous course.
Brazil’s country risk improved significantly. The 5-yr CDS fell from around 500 bps at the beginning of 2016 to less than half of that level currently.
This fall in risk is a result of the reform agenda that the government has embraced: spending cap, social security, education and labor reform, etc.
Brazil is now less vulnerable to external shocks.
Our balance of payment position is more comfortable. In February, the current account deficit reached 1.2% of GDP in twelve months. At the same time, direct investment reached 4.6% of GDP, almost four times the deficit.
Our international reserves stock exceeds US$375 billion, around 20% of the GDP, which works as insurance during periods of turbulence.
The BCB reduced the stock of FX swaps from US$108 billion to a current level of US$18 billion, reaching a more comfortable position.
Economic activity shows signs consistent with stabilization of the economy in the short run. Available evidence suggests a gradual recovery during the course of 2017.
In recent months, the efforts by the Central Bank and the government have been effective in containing inflation and anchoring expectations.
The figure for 12-month inflation fell from 10.7% in December 2015, to 4.6% in March 2017.
Inflation expectations for 2017 have declined continuously to around 4.1% currently. For 2018 and longer horizons, market analysts’ inflation expectation remains anchored around 4.5%, the current inflation target, or slightly below.
The Committee’s inflation forecasts for 2017 and 2018 in the scenario with interest rate and exchange rate paths extracted from the Focus survey are around 4.1% and 4.5%, respectively. This scenario assumes a path for the policy interest rate that ends 2017 at 8.5% and remains at that level until the end of 2018.
Real interest rates are falling in Brazil.
The policy rate (Selic) is on a downward path, given that inflation is declining, expectations are anchored around the target, and the level of economic slack is high.
The real ex-ante rate based on the 12-month fixed rate (from swap DI market) and 1-yr ahead expected inflation, after reaching approximately 9% in September 2015, fell to the current level of 4.6%.
Going forward, the pace of monetary easing will depend on the estimated extension of the cycle and on the degree of frontloading. In turn, the latter will depend on the evolution of economic activity, on the other risk factors highlighted in our official communication, and on inflation forecasts and expectations.
The policy rate fell from 14.25% in October 2016 to 11.25% in the last meeting, after a reduction of 100 bps. The Committee considers the current pace of easing to be appropriate; however, the current economic context calls for monitoring the developments of the determinants of the degree of frontloading of the cycle.
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The domestic economic outlook: economic policy in the right direction.
Economic policies and reforms implemented by the government in a short period have already shown positive results.
Several reforms and adjustments have boosted confidence and reduced risk perception of the Brazilian economy.
The country risk assessment of Brazil improved significantly. The CDS fell from around 500 bps at the beginning of 2016 down to below half of that level. This reflects increased confidence of international investors in the country’s solvency, in the implementation of reforms, in the determination to fight inflation, and in the recovery of economic activity.
The progress of fiscal reforms (particularly the approval of the constitutional amendment that sets a cap for government spending growth and the consideration of the pension system reform) has been positive and will be pivotal to the future performance of the Brazilian economy.
In recent months, the Central Bank and the government have been effective in containing inflation as well as in anchoring expectations.
The figure for 12-month inflation fell from 10.7% in December 2015, to 4.6% in March 2017.
Inflation expectations collected by the Focus survey are around 4.1% for 2017, around 4.4% for 2018 and around 4.25% for 2019 and longer horizons.
Not only market expectations, but also the Copom's inflation forecasts point to a benign outlook. In the scenario with interest rate and exchange rate paths extracted from the Focus survey, they are around 4.1% for 2017 and remained around 4.5% for 2018. This scenario assumes a path for the policy interest rate that ends 2017 at 8.5% and remains at that level until the end of 2018
Inflation developments remain favorable. The disinflation process is more widespread, and disinflation of IPCA components that are most sensitive to the business cycle and monetary policy has consolidated. Food price disinflation constitutes a favorable supply shock.
According to the scenario with interest rate and exchange rate paths extracted from the Focus survey, inflation developments should remain favorable during the current and the following year. For 2017, 12-month inflation is expected to remain below the 4.5% target during the year, reaching a trough in the third quarter and recovering in the final months to end the year a little below target. Part of this difference relative to the target is due to primary effects of the favorable food price shock. In this same scenario, inflation should hit the 4.5% target in 2018.
Higher inflation volatility is expected for April and May, due to temporary energy price revisions (Angra III). A fall of 30 to 40 bps is expected in the Consumer Price Index (IPCA) in April, although the price reversion, to a level similar to initial one, should generate an effect on the opposite direction and similar magnitude in May (with residual effects in June). This kind of volatility (sharp and atypical) does not have relevant implications for the conduct of monetary policy.
The baseline scenario involves risks in both directions:
I. The highly uncertain global outlook might make disinflation more difficult;
II. The next steps in the process of approval of fiscal reforms involve the consideration of reforms that are fundamental to fiscal sustainability, such as the social security reform. This process may be lengthy and involves uncertainty. These reforms and other necessary adjustments in the Brazilian economy are important for the sustainability of disinflation and for the reduction of its structural interest rate;
III. Disinflation in food prices constitutes a favorable supply shock, which might produce second-round effects, and, thus, contribute to additional reductions of inflation expectations and inflation in other sectors of the economy; and
IV. Economic activity points to stabilization in the short run, but its recovery might be more (or less) gradual and delayed than currently anticipated.
Given that expectations are anchored, inflation forecasts are around target for 2018 a little bellow that for 2017, and that the level of economic slack is high, the Copom’s baseline scenario prescribes frontloading the monetary easing cycle.
For a given estimated extension of the cycle, an increase in pace corresponds to a higher degree of frontloading. In its April meeting, the current outlook led the Committee to reduce the policy rate (Selic) in 100 bps to 11.25%.
The degree of frontloading depends, on one hand, on the evolution of the economy and, on the other hand, on risks and uncertainties that the economy still faces.
Yet again, empirical evidence has corroborated the important role of monetary policy, and of overall economic policy, for inflation control. It is important first to anchor inflation expectations and only then start monetary policy easing.
Economic recovery and the role of monetary policy
Economic activity has shown signs consistent with stabilization of the economy in the short run. Available evidence suggests a gradual recovery during the course of 2017.
Monetary policy should contribute to the economic recovery supported by other policy efforts.
Inflation developments remain favorable, allowing, among other factors, for monetary easing. The disinflation process is more widespread, and disinflation of IPCA components that are most sensitive to the business cycle and monetary policy has consolidated.
Economic growth depends on increasing levels of productivity. To that end, insisting on reforms, as we are doing in Brazil, is imperative.
First, approval of macroeconomic reforms is essential, particularly the ones of fiscal nature, such as the social security reform.
Microeconomic reforms related to efficiency gains, higher flexibility of the economy, and improvement of the business environment, are also essential.
The agenda also includes a tax reform and a labor-market reform.
Finally, it is also important to accomplish investments in infrastructure through concessions and other mechanisms.
Investment in infrastructure plays an important role in boosting productivity. These investments have a multiplier effect by reducing costs and risks for productive activities, increasing the expected return on other investments and making new projects more appealing to investors.
Monetary policy, the real and the structural interest rate of the economy
Currently, the policy rate (Selic) is on a downward path, given that inflation expectations are anchored around the target, actual inflation is declining, and the level of economic slack is high.
Real interest rates are also falling. Several measures confirm this fact.
The real ex-ante rate, based on the 1-yr fixed rate (from swap DI market) and 1-yr ahead expected inflation, after reaching approximately 9% in September, 2015, has remained stable, around 7%, during 2016 and declined afterwards, reaching the current level of 4.6% p.a.
When using the expected path for the Selic rate extracted from the Focus survey for the next 12 months (instead of the 1-yr fixed rate for this period) to calculate the current real interest rate, we also find values around 4.6% p.a.
The real interest rate implied by the NTN-Bs (inflation indexed government bonds) for the same time horizon has also declined, to the current level of around 5.3% p.a.
It is important to stress that an ex-ante real interest rate measure is the most appropriate one for monetary policy to monitor, because it is the variable that guides economic decisions.
In a historical perspective, the current level of the real interest rate is low. Over the past decades, the real interest rate of the Brazilian economy has fluctuated, showing a clear downward trend. It has declined from over 20% during the nineties to around 10% during a good part of the 2000s, reaching an average of 5% since then (this figure encompasses a period of unsustainably low real rates, of around 2% p.a., during the previous administration).
The real interest rate of the Brazilian economy is still undergoing a convergence process. A prospective fall of the policy rate in the future depends on positive developments that lead to a decrease of the structural rate of interest of the Brazilian economy.
The structural rate of interest depends on factors like productivity growth of the economy, prospects of fiscal policy, quality of business environment, efficiency of resource allocation through the financial system and adequate policy-making.
Estimates of the structural interest rate undoubtedly incorporate a high level of uncertainty. For this reason, evaluation of this rate requires judgment.
The rerouting of economic policy by the current government, including the approval and implementation of fiscal reforms, particularly the social security reform, in addition to other reforms and necessary adjustments, should contribute to the fall of the structural interest rate of the Brazilian economy.
It is important to reassess estimates of the structural interest rate of the economy over time. Such changes should not occur very often, but they are important to the conduct of monetary policy.
A more efficient financial system, with more free market credit, contributes to increase the power of monetary policy, reducing the need for large movements of the policy rate along the monetary policy cycle.
The Central Bank has acted in this direction. We are currently implementing the “Agenda BC+”, which is organized around four pillars aiming at: enlarging financial citizenship, improving the Central Bank legal framework, increasing the efficiency of the financial system and reducing the cost of credit.
The sustainable reduction of the cost of credit
The current process of monetary policy easing, together with structural measures, should contribute to reduce the cost of credit.
The structural and sustainable reduction of the cost of credit also involves a set of microeconomic reforms, in order to increase efficiency and productivity of the economy.
The Agenda BC+ includes several actions for the sustainable reduction of the cost of credit. These actions include encouraging good payment performances and provision of guarantees; reducing administrative costs; increasing competition in the financial system; and reducing subsidized lending.
Final Remarks
The current world outlook is uncertain, however within a context of gradual recovery of economic activity and improvement of economic fundamentals of the Brazilian economy.
In Brazil, several reforms and adjustments have boosted confidence and reduced risk perception of the Brazilian economy. Insisting in this direction, in particular with the approval of the pension system reform, as well as other reforms to boost productivity, will be crucial to support the disinflation process and the decrease of the structural interest rate.
Again, the empirical evidence has corroborated the important role of monetary policy, and of overall economic policy, for inflation control.
Real and nominal interest rates are falling in Brazil. The policy rate (Selic) fell by 300 bps during the past few months and it is expected to fall further. The real interest rate have also receded from values close to 9% p.a. in 2015 to 4.6-5.3% p.a. currently.
Going forward, the pace of monetary easing will depend on the estimated extension of the cycle and on the degree of frontloading. In turn, the latter will depend on the evolution of economic activity, on the other aforementioned risk factors, and on inflation forecasts and expectations.
The Committee considers the current pace of easing to be appropriate; however, the current economic context calls for monitoring the developments of the determinants of the degree of frontloading of the cycle.
In the context of anchored inflation expectations, monetary policy easing in Brazil should contribute to the resumption of growth, complemented by other policy efforts. The more we persevere in the reforms and adjustments of the economy, the faster will be the economic recovery, creating jobs and income for the Brazilian people.