Caution Is in Order Regarding Cutting the Interest Rate

BRAZIL ECONOMICS - Report 17 Apr 2023 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

Last week, bets grew about an early start of the monetary easing cycle, before the end of the second quarter. The optimism was not due to the quality of the fiscal framework announced by the government, but rather to the deceleration of the 12-month rate of the IPCA to 4.6% (5.6% a month ago). Indeed, the entire downward shift of the nominal yield curve was due solely to the decrease of breakeven inflation, with the real curve remaining unchanged.

The reduction of the 12-month IPCA was expected, due to the “base effect”, which for some time will continue producing lower 12-month inflation rates (likely lower than 4%). However, a responsible Central Bank will not react either to the announcement of the change in the fiscal framework (which only assures an increase in spending rather than generating the necessary primary surpluses) or to high-frequency movements of the inflation rate. Furthermore, given the strong inertia and the still unanchored expectations, it is simply too soon to start lowering the SELIC rate. Technically speaking, an easing cycle should only start when both inflation, free of the base effect, and expectations show clear convergence to the target, and the latter result is still distant.

We warn, however, that for inflation to decline, economic activity will have to continue decelerating, and this is one of the reasons the government is ratcheting up the pressure on the Central Bank to reduce the interest rate before this is technically warranted, in a “gesture of goodwill”.

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