Monday, April 2, 2012

Take it easy Brazil

When the Banco Central Do Brasil began cutting the benchmark Selic rate last year, we urged a bit of caution. As it has turned out, they have cut interest rates more aggressively than we thought, largely in response to the faster than anticipated slowdown in GDP growth, especially over the last 12-months.

Since August 2011 the Selic rate has been cut from 12.5% to 9.75% currently. The minutes from the latest monetary policy committee meeting (Copom) suggest interest rate cuts are nearly done. That’s entirely appropriate given ongoing structural issues that suggest inflation is far from dead and buried.

When we argued for caution on monetary policy, our point was that Brazil wasn’t suffering from weak domestic demand. The real problem is the strong exchange rate (excuse the pun) which has damaged competitiveness. However, that same exchange rate strength has given a boost to household real incomes that has supported growth in demand: retail sales growth has recently accelerated to 7.3%. At the same time the unemployment rate is at a 25-year low of 5.23 %. Wage growth is also accelerating ahead of an increase in the minimum wage. That does not make for a benign inflation environment.

There is no easy answer for Brazil. Remember our line that while emerging markets don’t have the same structural problems as the developed economies, they have their own structural problems. Brazil risks going down the path of relying on monetary policy to fix an economy constrained by broader structural factors. Supply-side reforms (sound familiar?), especially with regard to the labour market and aimed at boosting productivity seems a sensible path to take.

In the meantime it appears likely the central bank will bring the Selic rate down a bit further to around 9%. That’s low by historical standards. Headline inflation is also likely to move lower in the months ahead, but the authorities need to remain vigilant to signs of re-emergent inflation pressures. The biggest risk to long-term prosperity in emerging markets is any lack of commitment to contain inflation.