Brazil: What Would US Recession Mean for Brazil’s Monetary Policy Outlook?

A US recession probably worsens the central bank’s perception of risks, in light of potentially negative implications for the currency and thus for inflation expectations. Our global team is now calling for a recession in the US. What does it mean for Brazil’s monetary policy outlook? Brazil’s monetary policy committee (COPOM) is thus likely to stay on hold for longer, until if feels sufficiently comfortable to resume easing again. Accordingly, our new forecast sees a total of 50bp of rate cuts to 10.75% by end-2008, probably in 2H08. Our old forecast saw 100bp of rate cuts, starting in 2Q08.

What has not changed: our base case macro scenario remains fairly benign.

First, we expect domestic demand growth to remain strong, amid a combination of expansionary policies, rapid domestic credit growth momentum, supportive labor market conditions, upbeat consumer confidence and positive business sentiment. However, overall real GDP growth is set to slow next year as the drag from net trade intensifies – we expect 4.3% growth in 2008 after an expected 4.9% growth this year.

Second, consumer price IPCA inflation should remain below the 4.5% official target. We assume that strong investment growth since early 2006 will mature in time to boost Brazil’s supply response to strong domestic demand. Rising domestic output capacity, in turn, should help allay inflation concerns. Our 2008 forecast also assumes some moderation in food price inflation, which was by far the main culprit for an increase in headline inflation in 2007.

Third, monetary easing should resume in 2008. Even the central bank’s own model forecast sees inflation running below the target in 2008. So, there would be room for the central bank to be already cutting rates right now, if it were to follow a simplistic rule. However, after pausing in October 2007, we believe that the central bank is set to stay on hold for many months, given its risk-management approach and in light of its asymmetric perception of risks: it prefers to err on the side of caution. Still, if a scenario of below-target inflation consolidates, the central bank should be able to eventually resume cutting rates next year.

What has changed: central bank’s perception of risks should postpone monetary easing.

A US recession probably changes the central bank’s perception of risks. A recession in the US probably means a qualitatively different international environment in the eyes of Brazil’s COPOM. As the global economy slows down, downside risks to global trade volumes and to international commodity prices increase. Perhaps even more importantly, potential downside risks to capital flows into emerging markets like Brazil tend to worsen too. From the point of view of the central bank, a deteriorating global environment might put depreciation pressures on the Brazilian currency, which in turn could hurt inflation expectations. In all, while the base case scenario remains benign, the central bank’s perception of the balance of risks probably tilts towards more caution.

Our new call: rates on hold for longer. Our old forecast called for a total of 100bp in monetary easing in 2008, starting in 2Q08. Our new forecast now sees just 50bp of rate cuts next year (to 10.75% by end-2008), with monetary easing resuming later, in 2H08. Under a US recession assumption now, we think that the central bank will wait for longer until it feels comfortable enough that the international landscape will not spoil Brazil’s convergence story.

What are the risks to our new forecast? The main downside risk to our scenario would be a sharper-than-expected turnaround in capital inflows. If the capital account really dries up, on top of our expected deterioration in the current account, then the Brazilian real would suffer, even though the central bank could lean against currency weakening by selling reserves. In turn, currency devaluation could push inflation expectations up, complicating the central bank’s ability to cut rates. To be fair, there is potential upside risk too. Large interest rate differentials and the global weakness of the US dollar itself could support Brazil’s bilateral exchange rate. If capital inflows prove more resilient than we assume, the resulting currency strength would reinforce Brazil’s virtuous-cycle story.

The local yield curve continues to offer a premium, even against our new, more conservative outlook. The local curve is pricing in outright monetary policy tightening going forward. We continue to believe that rate hikes remain unlikely. It would take a significant deterioration in the inflation outlook for the central bank to embark on outright monetary tightening, in our view. A necessary condition for rate hikes, in our opinion, would be inflation expectations rising above the 4.5% target center. Even then, the central bank would still have a tolerance band of 2 percentage points around that center to play with, if it so chooses.

Bottom line

A US recession will keep Brazil’s interest rates on hold for longer, as it probably worsens the central bank’s asymmetric perception of risks. A global slowdown could have potentially negative implications for the currency and thus for inflation expectations. Brazil’s monetary policy committee is thus likely to stay on hold for longer, until if feels sufficiently comfortable to resume easing again. Accordingly, our new forecast sees a total of 50bp of rate cuts to 10.75% by end-2008, probably in 2H08. Our old forecast saw 100bp of rate cuts, starting in 2Q08.

By Marcelo Carvalho Sao Paulo
Morgan Stanley
December 11, 2007