The Central Bank’s Dilemma: to stop or not to stop?

BRAZIL ECONOMICS - Report 25 Jul 2022 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

At the next COPOM meeting, the Central Bank will likely increase the SELIC rate by 50 basis points, to 13.75%. Although this rate is strongly restrictive, will this mark the end of the monetary tightening cycle? The analysis of the balance of risks – domestic and international – indicates it would be a mistake to close the door to new increases. Besides the risks from the global economy, which are many, the domestic field is marked by the worse fiscal picture, alongside a rising political-institutional risk.

The sum of all these risks has already taken the exchange rate to R$5.50/US$ and the quotation of Brazilian 10-year CDS to more than 400 points. Besides all these indicators, the long end of the yield curve is characterized by a huge risk premium. In the absence of this premium, interest rates for 4 years or longer would converge to the sum of the inflation target (of 3%) and the neutral real interest rate (about 4%).

However, even if we were to sum a “forward premium” to this sum (7.0%), it would be far below the level of 13%, or more, which has been the recent pattern. The Central Bank is being forced to play a “non-cooperative non-zero-sum game” with the fiscal authority, and the only way it can accomplish its mandate is to focus only on the inflation target, no matter the cost. Based on all these risks, at the next COPOM meeting, the Central Bank would have to leave the door open to further increases.

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