Market Economics | Interest Rate Strategy - BNP PARIBAS ...

5.0%. Even for 2012, while the headline median
consensus forecast is stuck at the 4.5% mark, the
average forecast has already started to increase.
This suggests that the distribution of individual
forecasts in the sample is biased to the right-hand
side. Dangerously, if the official inflation target
becomes increasingly perceived as a floor rather
than a central policy goal, it may quickly loose its
relevance as an effective anchor for longer-term
expectations too.
On recent trends, and without a convincing policy
response, inflation could well start to threaten the
6.5% target ceiling. In that scenario, it would not be
unconceivable to start hearing talk about inflation
going above 7.0%.
After all, domestic demand is surging and resource
utilisation in the economy is high. Brazil’s local credit
conditions are supportive, consumer confidence has
soared to all-time highs and labour markets are very
tight. The unemployment rate keeps reaching all-time
lows and nominal wage growth has accelerated into
double digits.
Fiscal promises, FX concerns
The worsening inflation picture argues for a prompt,
decisive policy response. Fiscal policy is too
expansionary, including through quasi-fiscal stimulus
via aggressive credit extension at subsidised rates by
the national development bank (BNDES). While the
authorities have pledged to pursue more disciplined
fiscal policies, the challenge is to turn words into
action. Sadly, the recent policy track record does not
inspire much confidence, and observers remain
sceptical on whether authorities will walk the fiscal
talk. The recent reliance on accounting devices to
achieve official fiscal goals does not bode well for
fiscal credibility.
In the absence of sufficient fiscal tightening, the
burden of adjustment falls on monetary policy. As
noted above, macro-prudential measures such as
higher reserve requirements and credit restrictions
are no substitute for rate hikes, given differences in
the reach and transmission channels of these
alternative policy tools. In fact, international
experience suggests that macro-prudential policies
can prove self-defeating if they turn out to be a thinly
disguised excuse to avoid needed policy tightening. It
may be fashionable in international circles to talk
about macro-prudential policies, but there is no
substitute for effective policy tightening.
What about the currency? Today’s reluctance among
policymakers across emerging markets to let their
currencies appreciate can complicate monetary
policy. Brazil’s recent measures to curb capital
inflows call into question the role of currency
appreciation as a relevant channel for monetary
policy to have an impact on inflation. With the
currency channel partially blocked, do policies then
need to be tightened more than otherwise in order to
achieve the same end-result? In all, as long as
capital inflows remain strong but authorities resist
currency appreciation, emerging-market monetary
policymakers will continue to face a policy ‘trilemma’
if they try to target inflation and currency at the same
time while still living with capital flows. Something
has to give.
Monetary policy action: how bold?
It is high time monetary policy responded to rapidly
deteriorating inflation dynamics. Now under a new
administration, Brazil’s central bank has a unique
opportunity at its inaugural policy Copom meeting on
19 January to rescue its inflation-fighting credentials
with bold action. While a 50bp rate hike is widely
expected, the policy signal would be much stronger
with a larger hike (say 75bp or even 100bp), if
coupled with an unambiguously firm and explicit
commitment to do whatever it takes to bring inflation
back to the target in a timely manner. We trust the
central bank understands what is at stake, but
observers are uncertain whether there is sufficient
latitude for autonomous monetary policy action.
In addition, monetary policy across many emerging
markets seems more expansionary (on currency
fears) than domestic demand considerations alone
would dictate. That raises the issue of whether or not
individual central banks in emerging markets feel
they can be more lenient as peers elsewhere also
seem more willing to accommodate higher inflation
than usual.
One risk in Brazil is that inflation dynamics have
worsened to such a degree that a 50bp rate hike at
this stage might not be enough to re-anchor inflation
expectations. After all, given the usual policy time
lags and the pipeline inflation pressures that have
been building, inflation may rise significantly higher
before it starts to decelerate.
If the central bank is regarded as remaining behind
the curve, the concern is that domestic demand
would remain too hot for too long and inflation
pressures would build further. In that scenario,
inflation would eventually get to a point that ultimately
forces a more aggressive policy reaction.
A back-loaded policy path would likely mean that
rates would have to peak higher than otherwise,
thereby increasing the risks of eventual overtightening
and a resulting boom-and-bust growth
pattern.
Marcelo Carvalho 13 January 2011
Markets Mover
24
www.GlobalMarkets.bnpparibas.com