RIO DE JANEIRO, BRAZIL – Brazil is heading toward “stagflation” as the economy teeters on the brink of recession and inflation soars above the official target for the year, leaving the Central Bank (BC) in an increasingly difficult position.
How can the monetary authority deal with price pressures without causing additional damage to an economy ravaged by one of the world’s most lethal Covid-19 epidemics?
“In part this is happening in Brazil because higher production costs are putting pressure on inflation and affecting economic activity,” said Caio Megale, chief economist at XP Investimentos and a former member of Paulo Guedes’ team at the Ministry of Economy.
Like many, Megale believes that the Central Bank will keep inflation under control and that any outbreak of stagflation will be relatively mild.
But he recognizes the potential risk of rising inflation fueling future expectations, especially in an economy with a history of high inflation, where index-linked contracts and agreements still predominate.
The Central Bank raised the economy’s basic interest rate last month for the first time in six years, to 2.75%, from a record low of 2.00%, and indicated its intention to promote another 0.75 percentage point hike in May.
With 12-month inflation now at 6.1%, well above the central target of 3.75% for the year, the president of the Central Bank, Roberto Campos Neto, said the idea is to anticipate the tightening to keep expectations for 2022 and beyond under control and thus avoid sharp increases in the Selic.
Many economists evaluate that inflation will soon exceed 7%. The real has dropped almost 10% this year after retreating 25% last year, while data from the IHS Markit purchasing managers’ index show that input costs in manufacturing and services are the highest since the series began in 2007.
The fiscal outlook, with President Jair Bolsonaro yet to sanction the 2021 Budget and the government potentially on track to break its “spending cap” rule this year, are also fueling inflation fears.
RECESSION?
“Brazil appears particularly vulnerable to a larger and more persistent increase in inflation…given the unstable dynamics in the economy, public policies and politics,” Goldman Sachs economists wrote in a report, citing the exchange rate, the degree to which inflation expectations are anchored, and short-term policies.
Even though the Central Bank is raising the cost of borrowing, real interest rates are at -3.35%, the lowest level in more than 20 years.
Campos Neto has repeatedly defended the “partial normalization” stance of the Central Bank. “We need to move the rate, but still be on stimulative ground,” he said Tuesday.
This is largely because short-term growth prospects are deteriorating as the pandemic shows no signs of abating and fiscal and political obstructions in Brasilia contribute to undermining business, consumer and investor confidence.
Unemployment, meanwhile, has risen above 14% and may soon surpass the all-time high of 14.6% reached in 2020.
These dynamics are likely to persist for the next few months before mass vaccinations help the economy recover in the second half of the year, when shocks to commodity prices and exchange rates may also begin to lose steam.
Economists at BNP Paribas this week projected a technical recession, seeing the economy shrink 0.7% in the first quarter and 1.3% in the second.
But like many of his colleagues, Gustavo Arruda, head of research for Latin America at BNP Paribas, is confident that Brazil’s stagflation will be mild and short-lived -a far cry from the combination of energy price shock and spiraling wage increases that wrecked many major economies in the 1970s.
“Monetary policy will not run the risk of allowing inflation expectations to become unanchored,” Arruda said.
Source: Infomoney
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