Central Bank of Brazil Cuts Interest Rate Aggressively As Inflation Remains Moderate

At its March monetary policy committee meeting, the Central Bank of Brazil (BCB) decided to cut the benchmark SELIC rate (policy rate) from 10.50% to 9.75%, accelerating the pace of rate cuts. At the previous four meetings in August, October and November 2011 and in January 2012 the monetary authority had cut the rate by 50 basis points at each meeting. The bank is trying to stimulate an economy that has moved sluggishly since the beginning of the third quarter of 2011 (see Brazil: 7 March 2012: Brazil's GDP Growth Returns to Positive Territory in Q4) and wants to prevent contagion from external shocks such as the recession in Europe, slow growth in the US and a deceleration in China.

Monthly Inflation Stabilises at 0.5% per Month

Inflation, as measured by the extended consumer price index (IPCA), amounted to 0.45% in February 2012, slightly below than in January (0.56%). In September 2011-February 2012, monthly inflation averaged 0.50% without much deviation from the mean, which compares favourably with the monthly average rate of 0.8%—also the mode—recorded in the October 2010-April 2011 period. In January, the highest inflation by group was reported in education (up 5.62%), which is seasonal as tuition costs tend to rise at the beginning of the school year and books and related material have to be bought. Inflation was relatively high in healthcare, personal expenses and housing. On a very positive note, food inflation continued to decrease and prices in apparel, transport and communications actually declined. Another positive development is that the wholesale price index remained flat in January and February 2012, after decreasing 0.55% in December 2011. While IHS Global Insight does not expect a full pass-through onto consumer prices, this may certainly translate into a slowdown in the pace of CPI inflation as soon as March and April.

Is Inflation Too High?

The central bank embarked on a loosening monetary policy, therefore, inflation is not a concern for the monetary authority, and its priority is now economic growth. At IHS Global Insight, we agree with the bank that annual inflation, currently just below 6.0% and within the targeted band, is on a downward trend. The 12-month inflation rate in the food and beverages category, which registered 6.9% at the end of February 2012, had been the major driver of inflation in recent quarters. Nevertheless, high inflation (above 6%) has been reported in clothing, personal expenses, healthcare, housing, and education—clear evidence that there has been contagion from food inflation, and that rising prices are not a problem limited to food staples. On a positive note, inflation in the group of administered and supervised prices was 5.5% at the end of February, showing that those prices are not seriously misaligned, and that the government has not used this mechanism to contain inflation. The central bank administration is working under the assumption that prices of agricultural and food-related commodities will not increase at least in the near term so domestic food inflation is expected to vanish soon. In the past six months inflation has revolved around 0.5%, which is not a low rate but certainly meets the criteria of price stability of the central bank.

Rates are very high. The average interest rate for loans to individuals amounted to 45% at the end of January 2012, compared with 40% at end-2010. In the same period, the rate for loans to businesses increased from 27.9% to 28.7%.An argument in favour of the central bank's longer-term approach to interest rates is that they must definitely go down, as they are extremely high by any standard. Domestic credit continues to grow, though, sponsored by the government through the National Development Bank (BNDES) and, to a lesser extent, the other two big state-owned banks (Banco do Brasil and Caixa Federal), and so the monetary authority is cautious about the overall effect that interest rates may have on the economy. It is clear that the central bank has fears about the deceleration of the economy and wants to bring the interest rate to a less restrictive platform from the monetary policy standpoint.

Outlook and Implications

The Central Bank of Brazil (BCB) will continue to use inflation targeting as its main strategy for monetary policy, having announced that it will continue to target annual inflation at 4.5% (plus or minus 2 percentage points) during 2012-13. The BCB has successfully used the same target since 2005, but the target is relatively soft and the monetary authority is expected to be more aggressive—not soon, but at least in the medium term.

How Much Room Does the Central Bank Have for Relaxing Monetary Policy?

Interest rates are certainly very high in Brazil, so there is ample room for lowering rates. The government expects to close the fiscal gap by 2014; a key driver of balanced fiscal accounts would be lower interest payments on public debt. Authorities assume a policy rate at 8.75% (currently at 9.75%) for 2012-14. A major problem that the monetary authority faces is the risk of higher inflationary expectations and supply shocks, such as soaring prices of (food) commodities, as observed in early 2011. Despite very high interest rates, domestic credit continues to grow rapidly as some credits are subsidized by the government; the bank is acting to reduce this distortion. A key driver in the decision to lower rates since August 2011 has been the global economic environment and the sharp slowdown in GDP growth in Brazil experienced in the second half of 2011; given our forecast for a global slowdown and the still moderate, although declining risks for another recession in the US, it is likely that interest rate cuts will continue in the near future in Brazil, to close the year at the targeted 8.75%. The next policy meeting is scheduled for 18 April 2012.