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Brazil’s central bank will have to weigh potential price pressures from the U.S.-China trade war against prospects of a disappointing recovery when determining how long its easing cycle will last.
On one hand, worsening trade tensions - coupled with Argentina’s shock primary election result - may push Brazil’s real lower and consequently dissuade policy makers from more aggressive benchmark interest rate cuts. On the other, fresh signs of weak domestic activity may pave the way for an even steeper decline in the Selic.
Brazil surprised financial markets with a larger-than-expected rate reduction at its last policy meeting, joining peers from Chile to India that are also injecting stimulus. Prospects for borrowing cost cuts in Brazil were boosted by the advance of a crucial pension reform. For Bank of America Merrill Lynch chief economist David Beker, an additional 125 basis points in cuts are in store this year for Latin America’s largest economy provided its currency doesn’t steady at a weaker level.
"The risk to this outlook is a continued currency depreciation," Beker said. "The question is how far the exchange rate goes beyond 4 reais per dollar."
Read more: Brazil Central Bank Warns of Slow Pick-Up in Economic Growth
Recent financial market turbulence laid bare how sensitive rate cut forecasts are to swings in the currency. A 2.25% plunge in the real against the dollar last Monday prompted traders to scale back bets of a second straight half-point cut at the central bank’s next rate-setting meeting in September.
That drop in the real coincided with a plunge in the Chinese currency to the lowest level in over a decade, a move that provoked the ire of U.S. President Donald Trump. Relative calm just three days later led traders to reverse course and boost wagers Brazil’s central bank will lower the Selic to 5.50% next month. Still, local markets were rocked again in the aftermath of Argentine President Mauricio Macri’s landslide loss in Sunday’s primary vote which prompted fears of a spillover effect.
In speeches since the July 31 rate decision, Brazil central bank President Roberto Campos Neto said the country is prepared to withstand global volatility. He cited factors including a stock of international currency reserves and a low current account deficit.
Meanwhile, policy makers got a fresh reminder of the dire state of Brazil’s economy on Monday, when a key gauge of activity contracted in the second quarter. For Solange Srour, chief economist at ARX Investimentos, only an exchange rate between 4 and 4.15 reais to the dollar may cut the easing cycle short.
Read more: Brazil Economic Activity Gauge Flashes Recession in New Blow
"The debate surrounding monetary policy will be more tilted toward activity than the exchange rate," she said.
--With assistance from Marisa Castellani.
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