Historic Rate Cut to Record Low Shows Brazil Return to Normalcy

  • Central bank set to cut key rate to record of 7% on Wednesday
  • Inflation surged last time borrowing costs were this low

Brazilian central bank governor Ilan Goldfajn is getting the thumbs-up from investors to cut the country’s benchmark interest rate to a record low on Wednesday.

With inflation well within the target range, idle capacity, and fewer price distortions, Goldfajn can bring the country’s Selic rate to 7 percent, around half of the level just over a year ago. The vote of confidence is good news for a country that has been lurching from crisis to crisis for years, and to the central bank in particular, after its credibility was hit by a series of ill-timed cuts in 2012 that helped bring inflation back with a vengeance and heralded a credit rating downgrade.

"The current central bank board has won the battle of expectations," said Mauricio Oreng, a senior strategist at Rabobank. "The scenario is quite different from the last time the key rate was at a record low."

Limited price pressure and growth capacity of around 2.3 percent per year -- relatively low for most large economies -- allows Goldfajn to cut the rate to a new record low and keep it there at least through the end of next year, while inflation remains near the 4.5 percent target, according a central bank survey of economists. By contrast, former central bank chief Alexandre Tombini only held borrowing costs at the previous record low for six months before embarking on a tightening cycle.

"Brazil has an exceptional window of opportunity over the next two or three years," said Mauricio Molon, chief economist at Santander Brasil. "Both interest rates and inflation on a downward trend should support the country’s economy."

Unlike Goldfajn, his predecessor Tombini faced political pressure by then President Dilma Rousseff and her economic team to cut rates to "civilized levels". He continued cutting even with inflation above target and then abruptly backtracked as consumer prices surged amid external commodity shocks. The end of the commodities boom exacerbated growing budget deficits and a weakening currency that, in turn, fueled inflation.

Also unlike Tombini, a career civil servant and long-time central banker, the MIT-trained Goldfajn, 51, had stints in academia, consultancy and the private sector, last as chief economist at Itau Unibanco, Brazil’s largest bank by market capitalization. Tombini did not respond to requests for comment.

To be sure, Goldfajn’s monetary policy faces a series of risks, most notably uncertainty over next year’s presidential race and President Michel Temer’s efforts to narrow budget gaps by containing pension outlays. Goldfajn has said that approval of the government’s proposed pension reform is crucial to help contain inflation and keep structural interest rates low in the medium-term.

Early polls for next year’s presidential elections show market-friendly candidates lagging behind populist candidates including former President Luiz Inacio Lula da Silva and former Army captain Jair Bolsonaro. Both the potential rejection of Temer’s pension bill and rise of political outsiders have the ability to spark a sell-off in assets including the currency, thus stoking consumer prices.

Gustavo Loyola, former central bank governor, said Goldfajn may face the same situation as in 2002 when monetary authorities had to jack up rates by 850 basis points in response to investor fears that then front-runner Lula could wreak havoc with the economy once in office.

The central bank declined to comment.

Even so, the big difference from previous shocks that caused the currency to plummet and inflation to spike is that the central bank currently has time to react to potential bad news, such as negative fiscal or electoral news.

"For them to raise rates, you’d need a significant change in inflation expectations," said Tony Volpon, former central bank director and current chief economist at UBS Brasil CCTVM SA. "While not impossible, we’re a long ways from that."

— With assistance by David Biller, and Walter Brandimarte

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