June 10, 2020 / 2:29 PM / a month ago

Has inflation, Brazil's eternal bogeyman, finally been slain?

BRASILIA (Reuters) - Inflation in Brazil is on course to fall to an all-time low this year as Latin America’s largest economy sinks, giving the central bank leeway to keep interest rates lower for longer or reduce them closer to zero.

The crisis unleashed by COVID-19 will likely cause the biggest fall in gross domestic product since records began in 1900. With unemployment set to hit its highest rate in decades, demand is expected to tumble, exerting a strong downward force on inflation.

Figures on Wednesday showed Brazil in May registered the second steepest monthly rate of deflation since records began in 1980, and the lowest annual inflation, 1.9%, since 1999.

A move below 1.65% in the coming months, an uncontroversial hypothesis given the output gap and level of slack in the economy, would mark a new all-time low.

For a country that only a generation ago had hyperinflation of almost 7,000%, it is remarkable.

“Inflation is pretty much dead. The output gap is huge and high unemployment shows there is considerable slack, so it is hard to see the economy overheating any time soon,” said Marcelo Carvalho, head of emerging market research at BNP Paribas in London.

“So the conditions are there to cut rates more,” he said.

Graphic: Brazil infllation - monthly — here

The central bank’s benchmark Selic rate is currently a record low 3%, and widely expected to be reduced to 2.25% next week, a level policymakers indicated last month would be its floor.

Economists at JP Morgan last week changed their forecast for action by the central bank’s rate-setting committee known as “Copom.” In addition to the 75 basis points penciled in for next week, they now expect another 50 basis-point cut in August, which would take the Selic down to 1.75%.

For Brazil, that is closer to zero than most would have dared contemplate even a year ago. In real terms, factoring in inflation, it essentially would be zero.

“We expect policy to be re-calibrated to weaker growth, deeper disinflation, a stronger current account balance, and calmer global financial conditions,” JP Morgan’s Cassiana Fernandez and Vinicius Moreira wrote in a note last week.

Their estimates of the “Taylor Rule,” an economic model which uses growth and inflation to predict where interest rates should be, suggests rates could be cut below 1.75%, were it not for financial stability concerns that would raise.


Not only is inflation significantly undershooting the central bank’s target this year of 4.00%, expectations for next year remain well anchored too. According to the central bank’s latest weekly “FOCUS” survey of economists, inflation next year will be 3.1%, well below the official goal of 3.75%.

Graphic: Brazil inflation - annual — here

Part of the reason inflation expectations remain anchored is because of the credibility the central bank has built up in recent years with investors, business and the population at large.

Inflation has also been falling globally for years, with Japan and some other developed economies battling deflation. Yet two countries on Brazil’s vast border, Argentina and Venezuela, are proof that inflation can still flourish.

More immediately though, the Brazilian real’s 20% recovery since hitting a record low near 6.00 per dollar a month ago, the global market rebound, and Brazil’s swing to a record current account surplus in April also all buy the central bank time.

The exchange rate appreciation, in particular, alleviates any inflationary pressure that may have built up from its plunge earlier in the year, and cools financial stability concerns. Both could potentially tilt Copom to a more dovish stance.

Especially with inflation so weak to begin with.

“The real’s bounce will allow Copom to leave the door open a bit longer,” said Mauricio Une, chief Brazil economist at Rabobank in Sao Paulo.

He recently cut his 2020 GDP forecast to minus 7% from minus 4%, lowered his inflation forecast to 1.3% from 2.3%, and said unemployment could nudge 17% in the coming months.

Central bank President Roberto Campos Neto has expressed reluctance to follow many industrial countries in reducing borrowing costs to near zero, or in economist jargon, the effective lower bound.

Emerging market central banks have not built up the same level of investor trust in their institutions, faith in their currencies, or policy credibility over the decades like the U.S. Federal Reserve or Bank of England.

Campos Neto and his colleagues on Copom say nobody is quite sure where the lower bound is. Monetary policy director Fabio Kanczuk said last week the Selic was still “far from the effective lower bound” and that the 2.25% level was not “written in stone.”

Despite the upward pressure on longer-term rates from Brazil’s precarious fiscal position, with government debt at a record high and heading above 90% of GDP, sinking inflation and a deep recession may see policymakers err on the dovish rather than hawkish side.

Reporting by Jamie McGeever; editing by Jonathan Oatis

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