Inflation: warning signs that should be monitored

BRAZIL ECONOMICS - Report 01 Dec 2020 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Marcelo Gazzano

Inflation accelerated at the start of the second half, first led by the rise of food prices, but now the process is more disseminated. The depreciation of the exchange rate, which in 2020 has amounted to a bit over 30%, is the main culprit for this increase of prices, and the depreciation in turn is the consequence of the increased risk of government insolvency. If a credible fiscal anchor is maintained that risk will tend to wane, with the opposite happening in case of fiscal relaxation. This is the main uncertainty. Further currency weakening will generate a new cycle of pass-through to inflation. Although the median of the distribution of projections indicates that inflation should end 2021 below the central target, this is not the forecast suggested by asset prices. Not only is the inflation implicit in the NTN yields continuing to rise over all time frames (with predominance of the shorter ranges), the rising slope of the short end of the yield curve (up to 12 months) already indicates the SELIC rate will be 5% at the end of 2021. The Central Bank has been reiterating that it will only be able to maintain the forward guidance (the commitment to keep the SELIC rate at 2% for an extended period) if there is a credible fiscal anchor. Its insistent statements to this effect indicate that it fears that the effect of asset price forecasts on the SELIC rate in 2021 are nearer to the truth than those declared in the Focus survey. The Central Bank’s directors know there is no demarcation line of where fiscal dominance starts. This phenomenon typically does not emerge all of a sudden. Instead, signs appear here and there and become stronger, and may or may not be truncated. Signs worth worrying about have already appeared, and the course correction depends exclusively on fiscal policy.

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