Brazil’s Inflation Plunges, But Central Bank Won’t Say ‘Job Done’

Maria Eloisa Capurro
·5 min read
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(Bloomberg) -- After some of the world’s most aggressive interest-rate hikes, Brazil’s inflation has plunged by half in the past six months. That sounds like mission accomplished — except the central bank doesn’t see it that way.

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In fact, even though the bank’s benchmark now offers an inflation-adjusted return of almost 8% — a global high among major economies – traders reckon its next move is more likely to be another bout of monetary tightening than a victory-lap rate cut.

The reason, in short, is fiscal policy. Two big shifts in Brazil’s public finances are threatening to push prices up.

One is an increase in taxes, as measures to curb prices of energy and other staples – aimed at softening the blow from the past year’s commodity spike – go into reverse. The other is more spending in the pipeline, as President-elect Luiz Inacio Lula da Silva seeks to strengthen social supports.

When it comes to inflation, both those trends point in the same direction: upwards. And that’s the key reason why central bank chief Roberto Campos Neto and his colleagues insist they remain “vigilant” and won’t hesitate to hike again if needed.

Lost Income

Traders have abandoned their bet on rate cuts early next year. They’re now pricing in another increase in the benchmark Selic rate that will take it to 14% by March — up from the current 13.75%, already a six-year high. Most economists don’t anticipate another hike, but they also don’t see any easing before August. Credit Suisse, along with a handful of local firms, expects no cuts until 2024.

There’s a tendency to explain whatever happens with inflation as the result of action taken by central banks. But in Brazil, tax cuts did much of the work in slowing price-growth to 5.9% last month, from around 12% in mid-year.

The government of outgoing President Jair Bolsonaro, who lost the October election to Lula, lowered charges on utilities and fuel. Many state administrations did something similar. But the impact of those measures is already fading from year-over-year price numbers – and in some cases may be reversed. At least four states already passed legislation to raise sales taxes, and make up for the income they’ve lost.

Analysts at JPMorgan Chase & Co. calculate that rolling back the state and federal tax cuts could add 2 full percentage points to inflation, though they say that’s not their base case because the fiscal picture isn’t yet clear. Even without that impact, the JPMorgan team expects inflation at 5.2% next year, well above the central bank’s 3.25% target.

‘Even the Plate’

Lula’s plans are the big fiscal question-mark. The president-elect, who won’t take office until Jan. 1, has already taken command of the economic agenda.

He’s promised a higher minimum wage and pay raises for public servants. Congress has approved a bill that will raise the country’s spending cap by $28 billion, about 1.4% of GDP, to boost benefits for the poor. Investors also worry that Lula will expand subsidized public credit — cheap loans that could undermine the central bank’s efforts to keep money tight.

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The outlook has sent economists like Natalie Victal, at asset manager SulAmerica Investimentos in Sao Paulo, back to some text-book basics. “In the end, when there’s a fiscal expansion you need more restrictive monetary policy to even the plate,” she says.

Victal is focusing on how higher government spending tends to boost interest rates: via a weaker currency, an increase in risk premiums, and rising inflation expectations. She thinks the central bank will be able to cut rates starting in September, but now expects the easing cycle to end at 9%, more than a percentage-point higher than she’d previous foreseen.

Brazil’s real has held roughly steady against the dollar over the past six months. The country’s tight monetary policy, in other words, has shored up its currency – even if it hasn’t delivered the kind of appreciation that might be expected from real interest rates — borrowing costs adjusted for inflation — that are climbing toward 8%.

Meanwhile, credit-default swaps have risen this month, suggesting markets see more risk in Brazil.

Campos Neto has pointed to the recent increase in risk premiums as something that could raise inflation expectations, even though price pressures have been easing. The central bank chief says fiscal concerns are part of the problem. “There’s always two forces at play,” he told reporters last week.

Markets vs Majority?

Lula’s pick as finance minister, Fernando Haddad, has tried to soothe investors, saying that it’s not the time for a fiscal expansion. Still, analysts have interpreted the appointment of Haddad and several other ministers from the president-elect’s Worker’s Party as signs that the leftist group will have a stronger-than-expected influence over the economy.

Not that fiscal policy in Brazil is a straightforward right-left affair. The right-winger Bolsonaro appointed a famous budget hawk as his finance minister – then spent freely anyway through the height of the pandemic and beyond.

Brazil ran a fiscal deficit of almost 14% of GDP in 2020, one of the world’s biggest. The gap narrowed sharply the following year amid a strong economic rebound. Now it’s widening again as growth stalls.

So far, the signals are that government spending will be higher than under Bolsonaro, and fiscal constraints looser than when Lula first came to office back in the early 2000s.

With hunger on the rise and social tensions running high, in a divided nation that’s just been through a knife-edge election, there’s little appetite among politicians for the kind of belt-tightening that investors tend to favor, according to Richard Back, a political analyst at XP Inc. in Sao Paulo.

Eventually, “reality will impose itself,” says Back. But “an agenda like the one the market wants isn’t the majority right now.”

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