Brazil Central Bank’s Job Gets Harder as Neutral Rate Rises

(Bloomberg) -- As Brazil launches a new round of fiscal stimulus, its central bank forecast it will need even higher interest rates to fulfill its pledge to fight inflation with a “significantly restrictive” monetary policy.

Policy makers on Thursday increased to 3.5% from 3% their estimate for the country’s neutral interest rate -- which neither stimulates nor holds back the economy. It means that, discounting next year’s expected inflation rate, monetary policy would start to become contractionary at around 8.5%, according to a back-of-the-envelope calculation. The benchmark Selic currently stands at 9.25% after a series of aggressive hikes this year.

“Scenarios with higher fiscal risk include a higher neutral interest rate,” Fabio Kanczuk, the central bank’s outgoing economic policy director, said in a news conference after the new estimates were released. “As the central bank changes its opinion on the implicit probability of the alternative scenarios, so does the neutral rate change.”

Economists surveyed by the bank itself say Brazil’s neutral rate could be even higher, closer to 4% in real terms, considering the country’s fiscal outlook. That’s a reversal from the positive trend that brought down such estimates from a high of about 6% just seven years ago.

Concerns that President Jair Bolsonaro may further boost social spending ahead of his re-election campaign have been on the rise since his government pushed for the approval of a bill that eases austerity rules to free up about 106 billion reais ($18.6 billion) in the 2022 budget. 

Part of that money will be spent on cash transfers to the poor, likely to boost demand for some key services amid a challenging inflation outlook. But the government’s push to ease austerity rules has also eroded its fiscal credibility, contributing to a currency sell-off and an overall increase in Brazil’s risk premium. 

“Direct transfers certainly don’t help to tame inflation expectations,” said Marcos Mendes, a researcher at Insper Learning Institution and one of the authors of the spending cap rule approved by congress in 2016. “But the key is that fiscal policy is eroding the country’s credibility.”

What Bloomberg Economic Says

“We welcome the fact that the central bank is finally acknowledging that the neutral interest rate is now higher -- and that it may shift further up, depending on what happens on the fiscal front. This acknowledgment raises the bar on the hikes needed to make policy ‘significantly restrictive,’ as it desires.”

-- Adriana Dupita, Latin America economist

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Even after a relief in recent weeks, spreads on Brazil’s dollar-denominated bonds remain nearly 70 basis points wider so far this year, according to a JPMorgan index that works as a gauge of investors’ risk perception. Meanwhile, the real has weakened over 8% since the beginning of the year. 

The central bank led by Roberto Campos Neto has been the world’s most hawkish this year, raising interest rates by 725 basis points since March. Another hike of 150 basis points is on tap for February, as part of the bank’s commitment to bring monetary policy to “significantly restrictive” territory and fight inflation that remains above target through the foreseeable future.

But fiscal and political risks remain among the main challenges for the central bank ahead in the run-up to next year’s presidential election. 

“Weaknesses in the structural reform effort and permanent changes to the fiscal consolidation process could result in an increase in the structural interest rate,” policy makers wrote in the minutes of their latest monetary policy meeting last week. 

On Thursday, they revised down their growth estimates for this year and next as key reforms including an overhaul of the country’s tax system and another of public servant careers are increasingly unlikely to be approved by congress in 2022.  

“Central bankers say fiscal risks have increased but the market, including myself, is saying that they have actually materialized,” said Caio Megale, chief economist at XP Inc and former member of the economy ministry, who maintains an upward bias to his estimate for neutral rates given next year’s presidential elections. 

“At some point the market will move from worrying about the precatorios bill and the budget to what will be the economic policy of the next government,” he said.

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