There are two reasons why the Brazilian Central Bank might surprise the market on Wednesday and hold Selic steady at 14.25% – but a failure to raise interest rates would spell very bad news for the economy.
On Wednesday the Brazilian Central Bank’s (BCB) monetary policy committee – Copom – will meet to discuss raising the country’s base rate. With inflation running at more than 10%, against the bank’s target of 4.5% (plus or minus two percentage points), the market expects a 50bp rise, to 14.75%.
That consensus expectation is also the natural conclusion from the open letter that the central bank’s governor, Alexandre Tombini, wrote to the market in early January, in which he said: “Regardless of other policies the central bank will take the necessary measures to meet its inflation-targeting objectives.”
However, there is possibility that the Copom will vote to keep rates steady – and there is a significant minority of forecasters who believe the BCB will do so.
There are two main reasons the central bank may not raise rates, and if either, or both, end up driving this Wednesday’s policy decision then the implications for the Brazilian economy – already in its worst recession for more than 100 years – would be severe.
The first reason that Copom might not raise rates is political: there have been growing signals from the very top of government that it would like to see the bank prioritise growth over combatting inflation.
On 14 January, Reuters quoted an anonymous presidential aide as saying: “Our concern is that higher rates will again fail to bring down inflation while further sinking the economy.”
This political pressure is despite the fact that inflation is now above 10% and long-term inflation breakevens are close to 9% – signalling that a de-anchoring of inflation expectations appears to be under way. Worryingly, there have been rumours that the politicians may respond by raising the bank’s official inflation target, which is certainly the easiest way to help the bank to meet its objective but will just heighten future inflation expectations even further.
Copom: no fiscal help
Far from aiding monetary policy, recent fiscal steps have been expansionary. The government announced an above-inflation increase to the minimum wage, despite slack appearing in the labour markets. The government also increased social spending for 2016 above the rate of inflation and the new Minister of Finance, Nelson Barbosa, has signalled that he would be willing to increase subsidized loans through state-owned financial institutions (such ‘off-balance sheet’ fiscal expansion that was part of the cause of the current economic and political crisis).
As Royal Bank of Canada notes: “We doubt the BCB will hike because the fiscal picture is overwhelming any monetary policy tightening.”
The second reason Selic might be maintained at 14.25% would arguably be more serious for the Brazilian economy: if members of Copom don’t act because they have become convinced that Brazil is under the grip of fiscal dominance.
The theory of fiscal dominance means that, paradoxically, raising interest rates fuels inflation rather than dampening it. Brazil’s large public deficit – and high interest rates – mean that raising interest rates leads to much higher debt-servicing costs and therefore doubts about the government’s financial solvency. Investors sell government bonds and the currency falls. And so, ultimately, any increase in interest rates leads to currency depreciation and, via pass-through, an increase in inflation.
If policy makers see that the Brazilian economy has fallen under the influence of fiscal dominance any increase in interest rates would be counter-productive. This would mean that the Brazilian economy had entered into very dangerous waters. Officially, monetary policy would be deemed to be ineffective. And clearly there is little chance of fiscal policy restraining inflation in the short term (at least).
Earlier this month, The Economist reported that Credit Suisse economists have warned that, should fiscal dominance take hold, inflation rates could reach 17% next year. And with three-quarters of government spending index-linked, the spiral could get vicious.
Barclays is one observer who believes that the fiscal dominance argument is compelling. The presence of fiscal dominance, the bank says in a report dated 14 January, is why: “We think the BCB is unlikely to hike rates as aggressively as the 200bp that is currently priced in over the next two years. Rather, our base case is for the BCB to be on hold, although we do not discount the risk of symbolic rate hikes … in order to show the Central Bank’s commitment to its inflation target and retain its independence.”
If fiscal dominance has in fact taken hold, the BCB won’t be able to raise rates to counter inflation. Policy makers will have to accept that are no effective fiscal or monetary tools available to steer the economy. Inflation will continue to rise, the currency to fall, the economy to shrink and financial assets to fall in price. With apparently little or no hope of fiscal restraint from the present government, the risks to the Brazilian economy would remain heavily skewed to the downside, for 2016 and possibly years to come.