Brazil pauses after 21 rate cuts, no plans to trim stimulus

     After 21 rate cuts in almost four years, Brazil's central bank paused and kept its rate steady but said it was not planning to reduce the current level of monetary stimulus unless inflation expectations and the projected inflation rate gets sufficiently close to its inflation target in the next two years.

    The Central Bank of Brazil (BCB) left its benchmark Selic rate at 2.0 percent after cutting it 12 percentage points since October 2016, including five rate cuts this year by 250 basis points.

     Copom, the bank's policy-setting committee, said today's decision reflected its baseline scenario for inflation, a higher-than-usual variance in the balance of risk, and is consistent with inflation returning to its target over the forecast horizon that includes 2021 and to a lesser extent 2022.

     The decision to maintain the rate comes after the central bank last month said any remaining space for further monetary easing was now small and any further changes to the degree of stimulus would be gradual and depend on the outlook for fiscal policy and inflation.

     Copom said current economic conditions continue to call for "unusually strong monetary stimulus," but for prudential and financial stability reasons, the "remaining space for monetary policy stimulus, if it exists, should be small."

      Any "possible future adjustments to the current degree of stimulus would thus be gradual and depend on the fiscal trajectory as well as any changes to the bank's view of the path of inflation, Copom added.

     Copom said it would now use forward guidance as an additional tool of monetary policy to provide the stimulus considered adequate to meet the inflation target.

     Forward guidance has become widely used by central banks in advanced economies where interest rates have been close to the lower bound but less so in emerging markets where interest rates in general are higher and vulnerabilities of the financial system greater.

     Although BCB has used forward guidance on some occasions in the past, last month it specifically adopted the strategy of forward guidance to ensure market interest rates remain low.

     The central bank's president, Roberto Campos Neto, has acknowledged BCB is now testing the lower bound of interest rates for an emerging market country while also realizing the need for stimulus to help the economy recover after the COVID-19 pandemic.

      Brazil's inflation rate rose to 2.44 percent in August from 2.31 percent in July and Copom expects inflation to rise in the short term due to temporary increases in food prices and a partial normalization of prices of some service as part of a recovery of economic activity.

     However, measures of underlying inflation remain below the level that is compatible with meeting the bank's inflation target of 4.0 percent, plus/minus 1.5 percentage points, BCB said, adding inflation expectations from the weekly Focus survey show 2020 inflation of around 1.9 percent, 3.0 percent for 2021 and 3.5 percent for 2022.

     Copom's own inflation projections based on a constant exchange rate of 5.30 real to the U.S. dollar are around 2.1 percent for 2020, 2.9 percent for 2021 and 3.3 percent for 2022. This scenario also assumes the Selic rate will end this year at 2.0 percent before rising to 2.5 percent in 2021 and 4.50 percent in 2022.

     Brazil's economy shrank 9.7 percent in the second quarter from the first quarter, which shrank 2.5 percent, but the central bank said recent data suggested a partial recovery of economic activity.

      However, uncertainty about economic growth remains larger than usual, especially fore the period beginning at the end of this year in connection with the expected unwinding of stimulus programs.

     Earlier this month Campos Neto said the bank was forecasting a contraction in gross domestic product this year of around 5 percent and then a recovery of more than 4 percent in 2021.

    The Central Bank of Brazil issued the following press release:

"​In its 233rd meeting, the Copom unanimously decided to maintain the Selic rate at 2.00% p.a.

The following observations provide an update of the Copom's baseline scenario:

·      Regarding the global outlook, the recovery in major economies, although uneven across sectors, along with a moderation in financial assets volatility, is resulting in a relatively favorable environment for emerging economies. However, there is significant uncertainty regarding the evolution of this scenario due to a possible decline in government stimuli and to the evolution of the COVID-19 pandemic itself;

·      Turning to the Brazilian economy, similarly to other economies, recent indicators suggest a partial recovery in economic activity. Sectors more directly affected by social distancing measures remain depressed despite the offsetting effects of the government transfer programs. Prospectively, uncertainty about economic growth remains larger than usual, especially for the period starting at the end of this year, concurrently with the expected unwinding of the emergency transfer programs;

·      The Committee judges that short-term inflation will rise due to a temporary food price increase and to a partial normalization of some service prices, in a context of a recovery in activity and mobility;

·      The various measures of underlying inflation remain below the level compatible with meeting the inflation target at the relevant horizon for monetary policy;

·      Inflation expectations for 2020, 2021, and 2022 collected by the Focus survey are around 1.9%, 3.0%, and 3.5%, respectively;

·      The Copom's inflation projections in the hybrid scenario with interest rate path extracted from the Focus survey and constant exchange rate at R$5.30/US$* stand around 2.1% for 2020, 2.9% for 2021 and 3.3% for 2022. This scenario assumes a path for the Selic rate that ends 2020 at 2.00% p.a., rises to 2.50% p.a. in 2021 and 4.50% p.a. in 2022; and

·      The scenario with constant interest rate at 2.00% p.a. and constant exchange rate at R$5.30/US$* yields inflation projections around 2.1% for 2020, 3.0% for 2021 and 3.8% for 2022.

The Committee emphasizes that risks to its baseline scenario remain in both directions.

On the one hand, economic slack may continue to produce a lower-than-expected prospective inflation trajectory, especially when this slack is concentrated in the service sector. This risk increases if a slower reversion of the pandemic effects lengthens the environment of high uncertainty and precautionary savings.

On the other hand, fiscal policy responses to the pandemic that permanently aggravate the fiscal path or a frustration with the continuation of the reform agenda may increase the risk premium. Additionally, the credit and transfer programs implemented in response to the pandemic may cause a smaller-than-estimated decline in aggregate demand, introducing an asymmetry to the balance of risks. This set of factors could potentially result in a higher-than-expected path for inflation over the relevant horizon for monetary policy.

The Committee believes that persevering in the process of reforms and necessary adjustments in the Brazilian economy is essential for a sustainable economic recovery. The Copom also stresses that uncertainty regarding the continuation of the reform agenda and permanent changes to the fiscal consolidation process could result in an increase in the structural interest rate.

Taking into account the baseline scenario, the balance of risks, and the broad array of available information, the Copom unanimously decided to maintain the Selic rate at 2.00% p.a. The Committee judges that this decision reflects its baseline scenario for prospective inflation, a higher-than-usual variance in the balance of risks, and it is consistent with convergence of inflation to its target over the relevant horizon for monetary policy, which includes 2021 and, to a lesser extent, 2022.

The Copom believes that the current economic conditions continue to recommend an unusually strong monetary stimulus but it recognizes that, due to prudential and financial stability reasons, the remaining space for monetary policy stimulus, if it exists, should be small. Consequently, possible future adjustments to the current degree of monetary stimulus would occur with additional gradualism and would depend on the perception of the fiscal trajectory, as well as on new information that changes the Committee's current assessment about prospective inflation.

To provide the monetary stimulus deemed adequate to meet the inflation target, but maintaining the necessary caution for prudential reasons, the Copom considered adequate to use forward guidance as an additional monetary policy tool. Therefore, despite the asymmetry on its balance of risks, the Copom does not intend to reduce the monetary stimulus unless inflation expectations, as well as its baseline scenario inflation projections, are sufficiently close to the inflation target at the relevant horizon for monetary policy, which currently includes 2021 and, to a lesser extent, 2022. This intention is conditional on the maintenance of the current fiscal regime and on the anchoring of long-term inflation expectations.

The following members of the Committee voted for this decision: Roberto Oliveira Campos Neto (Governor), Bruno Serra Fernandes, Carolina de Assis Barros, Fabio Kanczuk, Fernanda Feitosa Nechio, João Manoel Pinho de Mello, Maurício Costa de Moura, Otávio Ribeiro Damaso, and Paulo Sérgio Neves de Souza."

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