Brazil Future Rate Cuts to Hinge on Prices, Congress Reform Push

  • Benchmark interest rate cut to 14 percent from 14.25 percent
  • Cut supports President Michel Temer’s economic growth agenda

Read Brazil’s central bank statement after its rate cut on Wednesday and there will be little doubt that an easing cycle has finally begun in Latin America’s largest economy. Any clue though on how deep and how intense this rate cycle will be lies closer to the country’s fractured Congress.

Policy makers led by Ilan Goldfajn voted to reduce the so-called Selic rate by a quarter point to 14 percent for the first time in four years, saying in an accompanying statement that moderate and gradual monetary easing is compatible with its mission to slow inflation to target next year. For Brazilian markets, the message was clear: further rate cuts are in store but, contrary to expectations, a more aggressive pace of easing may not materialize soon.

"We continue to believe that, under our assumptions of further fiscal reform, we are in for a long cycle that will take the Selic rate to 10 percent by the end of next year," Joao Pedro Ribeiro, an economist with Nomura Securities, wrote in a note to clients. "That said, we recognize that the likelihood of another 25 basis point cut in November has increased."

The move was a turning point for Brazil’s central bank, which had to hold the key rate at a 10-year high even as the economy plunged into its deepest recession on record. But recently, Brazil’s inflation has slowed, lawmakers approved a measure capping public spending and state-controlled oil company Petrobras reduced prices. More aggressive cuts will hinge on Congress passing further measures to control spending and more certainty that prices will continue to fall.

"Acceleration to a high pace of 50 basis point cuts is certainly not on automatic pilot," Goldman Sachs’ senior economist Alberto Ramos wrote in a research note. "That will require more tangible evidence that services inflation trends down and additional progress in the approval of the fiscal bills necessary to improve the fiscal outlook."

Interest rate futures rose sharply on Thursday, with traders now split between a Selic cut of 25 basis points or 50 basis points in the end of November. Earlier this week, a cut of half a percentage point had been fully priced in.

Slow Recovery

President Michel Temer took over on an interim basis in May promising to restore fiscal discipline and boost investor confidence after three years of primary budget deficits. His message struck a chord with investors. Brazil’s five-year credit-default swaps have dropped 64 basis points since he assumed the presidency on an interim basis, while the real has strengthened 25 percent year-to-date and the benchmark stock market index, the Ibovespa, has risen 83 percent in dollar terms in the same period.

Yet Temer faces an uphill battle to approve more controversial points of his reform agenda, particularly an unpopular pension overhaul. The arrest of former lower house speaker Eduardo Cunha on Wednesday adds to the uncertainty, as he could sign a plea bargain that some lawmakers fear would have devastating consequences in Congress.

The Brazilian economy has also been slow to recover from a recession that was exacerbated by nine months of political turmoil which ended in the impeachment of President Dilma Rousseff. Industrial production in August dropped the most on a monthly basis since January 2012, while retail sales have fallen in three of the past four months.

Latin America’s largest economy is forecast to expand 1.3 percent in 2017 after a contraction of 3.2 percent this year, according to the latest central bank survey of economists.

The benchmark interest rate needs to fall to help boost economic activity and also facilitate government efforts to strengthen fiscal coffers, according to Andre Perfeito, chief economist at the brokerage firm Gradual CCtvm SA.

"The economy doesn’t stop reeling, and for it to recover they’ll have to cut rates at least at the same pace as inflation slows," said Perfeito.

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