(Bloomberg) — Brazil’s central bank is facing a self-created emergency that threatens to sabotage years of nimble policymaking and credibility gains.
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Inflation forecasts are above the 3% target for the foreseeable future and confidence is collapsing as markets question whether the central bank – or the presidency – is commanding monetary policy. It’s a devastating reversal for an institution that was praised for its swift action against post-pandemic price hikes and subsequent rate cuts that were months ahead of advanced economies.
Investors are now worried about a repeat of the outlook seen under leftist President Dilma Rousseff more than a decade ago, when the central bank pushed inflation estimates even further above target while cutting rates as public spending rose. The institution risks another vicious circle, especially as Rousseff’s mentor, Luiz Inacio Lula da Silva, could appoint a majority of the board this year as he revives his demands to lower borrowing costs.
The crisis is coming to a head ahead of a June 19 policy decision that is the most important in recent memory. The central bank’s credibility was called into question after May’s split vote that pitted the majority led by Governor Roberto Campos Neto against directors tapped by Lula, who favored a bigger rate cut.
“It is fair to say there is a crisis of confidence,” said the central bank’s former director of international relations, Tony Volpon. “And the central bank is to blame for this.”
Policymakers tried to play down concerns about political interference and acknowledged that a preliminary change in guidance had not been discussed across the board. However, fears that the institution will be more tolerant of inflation are exacerbating the sense of deja vu in markets, as rising fiscal tensions also reflect a turbulent period that began in 2011.
In August 2011, the central bank came under attack starting a cycle of easing when markets expected the Selic to be kept high. Inflation estimates for the next two years jumped by about 30 basis points and were later boosted by Rousseff’s push for lower rates to help the economy.
Policymakers finally capitulated in early 2013, when they embarked on a tightening cycle that raised rates by nearly 4 percentage points ahead of next year’s election, only to tighten even more after the vote. While the current board has given no indication that it plans to lift borrowing costs now, speculation is mounting that such a policy change could become imminent.
“You can still win this battle without raising interest rates,” said former central bank monetary policy director Reinaldo Le Grazie, underscoring that unanimous rate decisions strengthen monetary policy in the eyes of markets. “But it’s getting harder to do that.”
Two-year yields have risen 48 basis points to 5.03% since the May 8 interest rate decision. Economists in a weekly central bank survey raised their inflation forecasts for 2024 for a sixth straight week and their estimates for 2025 for a seventh, according to data released on Monday. Traders are expecting at least half a point in the cost of borrowing to rise by the end of this year, with those bets partly driven by the risk premium.
“Perhaps it will be necessary to raise interest rates in order to anchor long-term expectations again,” said the central bank’s former economic policy director Fabio Kanczuk.
The Central Bank of Brazil declined to comment for this story. In a June 10 speech, Campos Neto said consumer prices are converging as expected toward the target, even as inflation forecasts continue to remain unanchored. This phenomenon “hasn’t happened many times in the past,” he said.
Premature comparison
For Volpo, who joined the monetary authority in 2015, Brazil is still far from raising rates, a view shared by most economists. However, he urged policymakers to take into account the lessons learned about the high price of losing credibility.
“It was horrible. We raised rates and inflation expectations were still unanchored,” he said. “At the end of the day, once you’ve lost credibility, getting it back requires a more orthodox, tighter and more restrictive monetary policy.”
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“The comparison with the period 2011-2014 is premature for several reasons. First, although the fiscal situation is far from ideal, there is much more transparency in both policy and fiscal data than there was then. Second, the level of market scrutiny is much higher now, given the state of global and domestic liquidity, than it was in 2011. Third – and not least – a dissenting vote that is technically justifiable is not enough to reach conclusions about the profile of the board members”.
— Adriana Dupita, Brazil and Argentina economist
Investors fear the central bank will become softer on consumer prices once Lula – who has also argued for a higher inflation target – appoints a new governor and two new directors later this year.
Indeed, these tensions will make it more difficult for the leftist head of state to decide on a successor to Campos Neto, Le Grazie said.
For Volpo, the current board will have a crucial chance to calm the waters by voting in unison, and resisting political pressure, in this week’s decision.
“There has to be unanimity,” he said. “The bank’s credibility is at risk.”
Hard to regain control
The loss of control of inflation expectations starting in 2011 stemmed from policymakers’ weakness in consumer prices, according to a study published this year by the central bank’s former economic policy director, Carlos Viana, among others. Their work concluded that the process of re-anchoring was complex and gradual, with estimates coming under control only in 2016.
Going forward, public spending will be key if inflation forecasts in Brazil are to come down. Investors were disappointed by the announcement in April that the government will seek a balanced primary budget next year, not a surplus.
Finance Minister Fernando Haddad recently expressed concern about Brazil’s fiscal outlook during a meeting with investors this month, sending assets plunging in a stark reminder of the market’s sensitivity to the issue.
Brazilian central bankers are also getting no help from the Federal Reserve, which has signaled it will wait longer before starting its easing cycle.
However, Brazilian policymakers’ biggest challenges come from within, according to the central bank’s former director of international relations, Alexandre Schwartsman.
“The hypothesis is that there will be a new central bank board with a weaker commitment to the inflation target,” he said. “There is a direct question of the credibility of the central bank.”
–With the help of Giovanna Serafim.
(Updates market movements and economist survey data in paragraph 10)
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