BC has reasons to cut interest rates, but also to maintain them

Judging by financial market expectations, it will not be this time that the basic interest rate will fall. The Central Bank’s Monetary Policy Committee (Copom) concludes its meeting this Wednesday (21) and, according to projections collected by the BC itself, banks and consultants believe that the Selic will be maintained at the level of 13.75% per year.

According to the same economists, the beginning of interest cuts will be at the August meeting, with a decrease of 0.25 percentage points. The scenario today is more favorable than that of previous meetings. However, there are still some risks on the horizon.

The main factor behind the drop in interest rates is that inflation expectations are falling, driven mainly by food and industrial goods. Other factors that can contribute to a cut in interest rates are:

• the possibility of a slowdown in the economy in the coming months;
• noise reduction in the economic area; It is
• the more benign external environment, which is reflected in a cheaper exchange rate.

But there are also signs that show that the Copom may continue with a more cautious posture and push the Selic rate reduction further forward. Among them are:

• the possibility of economic activity remaining heated, as has already occurred beyond expectations in recent months;
• a deterioration of public accounts, motivated by a more expansionist government policy;
• eventual impacts of the tax reform; It is
• reduction in the interest rate differential between Brazil and other countries, which could attenuate the appreciation of the real against the dollar.

A point of attention is the meeting of the next 29th of the National Monetary Council (CMN), formed by the Ministers of Finance and Planning and by the President of the BC, which will define the inflation target for 2024 onwards.

Itaú points out that the most likely scenario is maintaining the target at 3% and the tolerance band at 1.5 percentage points. Other modifications can be contemplated, points out the bank, such as the transformation of the target regime determined at the end of the year to a “continuous target”.

“A change in the horizon for meeting the target and/or widening the tolerance band around it would be negative. The CMN’s decision should impact the formation of inflation expectations and, ultimately, the conduct of monetary policy”, cites the bank’s report.

This Monday (19), President Luiz Inácio Lula da Silva (PT) once again demanded the reduction of the Selic rate and criticized BC President Roberto Campos Neto. “Only the interest rate needs to go down, because there is no explanation. The president of the Central Bank needs to explain, not to me, because I already know why he is not going down, but to the Brazilian people and the Senate.”

On the same day, questioned by journalists about the forecast cut in interest rates starting in August, the Minister of Finance, Fernando Haddad, said that the fall should have started earlier. “For me, it should have been March. Let’s see, let’s wait,” he said.

The factors that contribute to the reduction in the interest rate

Here are four factors that can contribute to a reduction in the interest rate:

1. Lower inflationary pressure

The midpoint of expectations for the 2023 IPCA has been falling for five weeks, a period in which it retreated from 6.03% to 5.12%. The bets for 2024 – the period to which BC is most attentive at the moment – ​​fell from 4.13% to 4%. And those for 2025 and 2026, from 4% to 3.8%.

Food prices are better behaved due to the super harvest, estimated at 315.8 million tons by the National Supply Company (Conab), and the drop in prices of agricultural commodities.

International prices fell by 2.6% in May compared to April and 22.1% compared to March 2022, when the peak was recorded, according to the Food and Agriculture Organization of the United Nations (FAO, in its acronym). in English).

Lower inflation of industrial goods is also expected. XP’s projection for this group fell from 2.9% to 2.6%, driven by the appreciation of the real against the dollar. The US currency has fallen 8% since the beginning of the year.

Also contributing to the drop in inflation expectations are the reductions in fuel prices, lower inflationary inertia for next year and the market’s perception that the chances of changing the inflation target have diminished.

2. Possibility of GDP slowdown

GDP surprised by growing 1.9% in the first quarter, and the Central Bank Economic Activity Index (IBC-Br) grew by 0.56% in April. Despite this, expectations are for a slowdown in the pace of growth in the coming months, which would reduce demand pressures on inflation.

According to the IBGE, GDP grew 3.3% in the 12 months through March. For the year 2023, the median of projections from the Focus bulletin, from BC, points to an increase of 2.14%.

The services sector should be one of those responsible for the lowest impulse of economic activity. Analysts at the MUFG Brasil bank point out that the activity should have difficulties to expand due to the still restrictive monetary policy, the indebtedness of families and the growth of defaults, which affect credit conditions.

Industry is another brake. The sector’s GDP shrank for the third consecutive quarter and production retreated more than expected in April – the accumulated drop in the year is 1% compared to the same period in 2022.

3. Less noise in relation to economic policy

Noises regarding economic policy have diminished in recent months, contributing to the reduction of country risk. The main indicator – the five-year credit default swap (CDS) – fell from 223 points, in May, to 185 points, on the last day 16. The instrument is a kind of insurance against defaults and is the first time since September 2021 which drops below 200 points.

The risk rating agency S&P, on the 20th, changed the perspective of the Brazilian sovereign risk from stable to positive. The company stated that the fiscal framework may result in lower indebtedness than expected so far.

Despite being criticized by economists who monitor public accounts, the proposed fiscal framework helped to reduce part of the uncertainty linked to fiscal policy, ruling out extreme scenarios of public debt growth – currently at 73.2% of GDP, according to the Central Bank. There is also a perception of advances in tax reform.

Copom highlighted in the minutes of the last meeting that the processing and implementation of the fiscal framework will be monitored.

4. More favorable external environment

The external environment is also less complicated, although the European Union (EU) has increased interest rates for the eighth time in a row and needs, according to the IMF, even higher interest rates and a stricter fiscal policy.

In the US, on the other hand, the Federal Reserve (Fed, the local BC) at least temporarily stopped raising interest rates. Jerome Powell, president of the institution, said he would not hesitate to raise rates if necessary.

The assessment of economist Francisco Nobre, from XP Investimentos, is that the cycle of monetary tightening in developed economies is coming to an end and commodity prices remain relatively high, despite the downward correction in agricultural products.

“We believe that the dollar will weaken in the coming months, albeit moderately, thus benefiting the currencies of other developed countries and emerging economies”, he says.

He highlights that this positive environment should persist, despite the need to closely monitor geopolitical risks.

The factors that hinder the reduction in interest

See, below, four possibilities that may make it difficult to reduce the interest rate:

1. Economy still heated

The chance of a greater increase in GDP is one of the factors playing against the drop in interest rates, by keeping demand heated.

The BC’s current projection is for growth of 1.2% this year, almost one percentage point below the median expectation of the financial market. The strongest advance, according to Itaú, “may also lead to upward pressure on the expected inflation path”.

Although some indicators lost steam in April, the bank points out that the job market is still resisting: “The April Caged pointed to the creation of 180,000 formal jobs, The seasonally adjusted unemployment rate fell from 8.8% in March to 8.5% in April, showing a still strong job market”, says the report.

Bradesco, meanwhile, states that “the data reinforce a still positive dynamic coming from household consumption, which should lead to some GDP growth in relation to the first three months of the year”.

2. Deterioration of public accounts

Another focus of concern for economists and the Copom is the adoption of a more expansionary fiscal policy by the government, which would put pressure on inflation and worsen expectations for public accounts.

Public administration consumption expenses grew 0.3% in the first quarter compared to the previous one, according to the IBGE. It is the third consecutive upward movement.

There is also a downward trend in the primary surplus (which does not include interest expenses) since the beginning of Luiz Inácio Lula da Silva’s (PT) government. The accumulated result for the 12 months ending in April was R$56.2 billion, or 0.6% of GDP. That’s a 0.9 percentage point decline from a year earlier.

According to XP Investimentos, the trend should remain negative: “We believe that the decline in commodity prices and the loss of traction in economic activity will affect tax collection in the coming months”.

On the expenses side, the brokerage recalls that the increase in the minimum wage and the salary readjustment for civil servants should weigh on public accounts from May onwards.

3. Interest differential

One factor that the Copom should closely monitor is the interest rate differential between Brazil and the rest of the world. Interest rates rising abroad and falling here may mean the entry of fewer resources into Brazil, which may raise the exchange rate.

“With the monetary easing process beginning in the second half of the year, Brazilian monetary policy would become a complete outlier [ponto fora da curva] in the global scenario, which is still in a synchronized process of monetary tightening, mainly in the US and Europe. In such an unprecedented situation, the effect on the Brazilian real of going against global monetary policy could be even more exacerbated”, highlights Genial Investimentos.

The midpoint of expectations for the exchange rate at the end of the year is R$ 5, according to Focus, which would represent an increase of 4.3% compared to this Tuesday’s quotation.

4. Impacts of the tax reform

A threat to inflation in the coming years may come from tax reform, points out Genial Investimentos. This would occur due to the increase in the average rate charged on services under the new IVA (Value Added Tax).

“To keep the tax collection constant, goods, which are currently heavily taxed, would suffer a reduction in the burden, while services, which are currently low-taxed, would suffer an increase in the burden”, highlights the brokerage.

The rebalancing of tax rates would generate an upward effect on prices, since most of the household consumption basket is made up of services.

“An additional challenge for the success of the new tax structure, given an already high burden and a non-transparent system, would be effective communication on the part of the government and a well-done transition process, under penalty of dissatisfaction with the reform”, emphasizes the brokerage analysis team.