Fiscal target in check and external worsening limit interest rate drop – 10/28/2023 – Market

With the worsening of the external scenario and the increase in fiscal uncertainty due to the speech of President Luiz Inácio Lula da Silva (PT) about the fiscal target, the financial market sees limited space for a fall in interest rates during the current cycle of cuts in the basic rate ( Selic).

In the short term, economists are betting that the Central Bank’s Copom (Monetary Policy Committee) will not change its strategy. There is a consensus that a new cut of 0.5 percentage points will be made next Wednesday (1st), which would take the Selic rate to 12.25% per year.

Uncertainties focus on the scenario ahead. Lula’s declaration that the 2024 fiscal target does not need to be zero and that the government will “hardly” achieve this objective caused future interest contract rates to soar.

Analysts, however, were already putting the fiscal target in question long before the Chief Executive’s speech and incorporating this into projections for the Selic’s trajectory in the coming months – now also incorporating the deterioration of the international environment.

Caio Megale, chief economist at XP and former advisor at the Ministry of Economy, says he is more optimistic in the short term and pessimistic in the medium term. Later this year, he expects positive news for the domestic scenario, with a decline in inflation. However, he considers that this relief will be temporary.

In September, the official inflation index – IPCA (Extended National Consumer Price Index) – rose less than expected and, accumulated over 12 months, stood at 5.19%. The trend for October shown by data from IBGE (Brazilian Institute of Geography and Statistics) is one of deceleration.

“There is no risk of him [BC] think about stopping interest cuts in the short term. In my view, a 0.75 cut would be more likely [ponto percentual] than 0.25 at some point, for a meeting in December or January”, says Megale.

“For the short term, the runway is clear. But, at some point ahead, there will be room for cuts, with the fiscal situation more uncertain and higher interest rates abroad”, he adds.

For the economist, fiscal uncertainty will not end with the vote on the 2024 Budget and will continue until the release of the first bimonthly report evaluating primary revenues and expenses, in March next year, when the need to impose or not a billion-dollar brake on spending.

In market calculations, pursuing the goal of zeroing out the deficit could lead the Lula government to block R$53 billion at the beginning of 2024. The exact value of the squeeze would only be known with more concrete data on the evolution of tax collection and the progress or not of revenue recovery measures sent to the National Congress.

“When there is the first bimonthly review and it shows that the fiscal is more uncertain – it will probably be more like a deficit of 1% of GDP [Produto Interno Bruto] than for balance [das contas públicas]– it is possible that the Central Bank will slow down and stop [de cortar juros] to observe”, projects Megale.

At the breakfast where he dismissed the need for a zero deficit next year, Lula also defended measures to face the international slowdown in 2024. “Obviously we know that next year presents itself as a difficult year due to the drop in investment of China, the decline in China’s growth and the increase in American interest rates”, said the president.

The risk of fiscal expansion next year due to the slowdown in economic activity is a point of attention for Rafaela Vitória, chief economist at Banco Inter.

“The activity [econômica] weak may bring back speculation on countercyclical policies [ações que buscam expandir a economia em um momento de retração]which we don’t think is appropriate at a time when inflation begins to converge towards the target more clearly, but we understand that the government flirts with these fiscal expenditures”, he states.

She points out that the increase in the supply of subsidized credit would hinder the process of falling interest rates and disagrees with the monetary authority’s decision to have removed the fiscal issue from its balance sheet as a risk factor for rising inflation.

Despite the warning, Vitória considers that the BC still has a lot of room for Selic cuts in the next meetings and says that a moderate pace of decline of 0.5 percentage points is compatible with an internal scenario of lower inflation and greater external risk.

Since the last Copom meeting, in September, the profitability of treasuries – United States Treasury bonds – has soared, interest rates in developed countries have continued to rise and the conflict between Israel and Hamas has broken out, which could make oil more expensive and boost inflation global.

Felipe Salles, chief economist at C6 Bank, considers that the international scenario could generate “some discomfort” for the BC and highlights that future interest rates in Brazil followed the upward movement of American peers.

“The market is saying the following: with this external scenario, with this worsening abroad, treasuries [títulos do Tesouro americano] rising, the space to cut interest rates in Brazil decreases”, he said.

“This could cause discomfort for the BC in terms of cutting the Selic rate at a time when the long curve is under more pressure. It will be interesting to see how the Central Bank will position itself in the face of this change in the global scenario”, he continued.

In his view, emerging economies – including Brazil – will need to learn to live with high American interest rates for longer. For Salles, this context should make Copom recognize in its statement that the scenario is more challenging.

But he considers that the war in the Middle East has so far had a small impact on global markets. And, based on the most recent communications from BC leadership, he does not see significant changes that would lead the board to change its flight plan.

For Juliana Inhasz, economics professor at Insper, a 0.25 percentage point cut in the Selic would be “technically more appropriate” at a time of more caution and deterioration in global conditions.

However, she expects the BC to opt for a further drop of 0.5 percentage points due to the great political pressure from the Lula government for greater monetary easing.

The expert also says that she would like to see divergence in the votes of the members of the BC board, which would signal to the market the monetary authority’s concern with the current global scenario.

“If we don’t have this divergence, this will indicate that the BC is much more focused on a desire for a quick fall without balancing the risks too much in an environment of uncertainty. Maybe we won’t have unanimity. This doesn’t mean that the [grupo] pro-government won’t get the upper hand”, he says.