July 27, 2011

Brazil: Growth and Policy Mismatch? (Guest Post)

By Arthur Carvalho of Morgan Stanley
(via Investment Postcards)

Brazil’s central bank's 25bp rate hike last week brought the Selic rate to 12.5%.  But in contrast with most Brazil watchers, we believe that move could be the central bank’s last move for the year. We interpret recent comments by the central bank as suggesting that it will end the rate-hiking cycle by August and possibly as early as this week.

And given the growing uncertainty in the global environment, it would be easy to imagine a decision at the end of August indicating that it is time to hold off on additional rate hikes even if such a decision is not clearly telegraphed at the July meeting.

Our forecast of the central bank’s likely path – last rate hike in July to 12.5% and then on hold through next year – is not set in stone. We have held for nearly a year now that the hiking cycle would end at 12.5% and do not see enough reason to adjust our forecast. If we had held, as many now do, a hiking cycle ending at 12.75% we would probably not adjust our forecast either: there is simply not enough evidence to date to define with greater certainty if the central bank’s overnight interest rate target is set to reach 12.5% or 12.75%.

But what does seem clear is that the central bank is approaching the end of the hiking cycle: that can be seen in the central bank’s diagnosis of inflation, its assessment of its action’s success and its understanding of the usual policy lags.

The View from the Central Bank

Look at the central bank’s diagnosis of inflation: inflation is largely a supply shock that erupted in the last months of 2010 in international commodity markets, combined with supply disruptions in a few localized domestic markets (most prominently beef) and compounded by weather-related shocks at the beginning of 2011. Did robust demand play a role in adding to inflationary pressures? Most certainly, and the central bank clearly recognizes that. But at the core, the origin of the uptick in inflation at the beginning of the year was a string of supply problems.

Now look at the central bank’s assessment of the success of its actions: inflation has plummeted after averaging 0.73%M during the first five months of the year. Indeed, the central bank’s models are forecasting monthly inflation at half that pace in the last seven months of the year. Certainly, the drop-off at mid-year is in part due to seasonal factors and there will likely be a gradual uptick towards the end of the year as seasonality works in the other direction. But inflation is on a path that the central bank believes is consistent with a return towards the 4.5% target.

Of course, the return to a 4.5% path does not mean that inflation is set to reach 4.5% this year – the central bank’s own modeling puts inflation at 5.8% for end-2011. And the central bank seems to have contemplated that the August inflation reading, if measured on a year-on-year basis, is likely to show a peaking of the annual readings near 7% (above the 6.5% upper limit of its inflation band).

Finally, look at the central bank’s understanding of the usual policy lags: it is not likely to be until September or 4Q11 that the ‘full force’ of its actions are felt. While it is possible that the central bank keeps hiking throughout the remainder of the year, we believe the much more likely outcome is that the central bank decides to stop and argue that it is time to wait and assess the full impact of its actions. Monetary and macroprudential policies work with a lag, and the central bank believes that the six to nine-month lag remains in place.

Service Pressures

We remain concerned about Brazil’s inflation picture. On the one hand, we agree with the central bank’s emphasis on the role that supply disruptions played in the inflation scare at the end of last year and the beginning of 2011. We argued then that inflation was being misdiagnosed: Brazil had an inflation problem, just not the one that most analysts were focusing on.

We argued that the uptick was concentrated in a handful of food items and that the risk of inflation spiraling ever higher was being overplayed by many. But our concern then is our same concern now: the rapid growth in domestic demand has pressured services or non-tradeable prices during the past two years. With unemployment running at record lows, an overheated labor market is producing pressure in wage inflation and service prices. Is inflation likely to spiral ever higher? We don’t think so. Is it consistent with a return to 4.5% inflation? We doubt it.

We believe that Brazil’s inflation problem is the outgrowth of the Growth Mismatch (robust demand facing sluggish supply) and the policy response to date. While the central bank has hiked interest rates by 150bp this year (and we expect total hikes this year of 175bp after this week’s meeting) and implemented macroprudential measures, we are concerned that much more needs to be done on Brazil’s fiscal and quasi-fiscal fronts.

With demand still growing much more rapidly than potential and easily outstripping supply, Brazil needed to engage in counter-cyclical fiscal policy in 2010. The efforts to rein in spending announced this February are a valuable step, but as long as Brazil is set to run a significant overall budget deficit, we worry that not enough is being done.

Can the Growth Mismatch Self-Correct?

For a year now, we’ve been arguing that a multi-decade strong exchange rate is simultaneously boosting consumer demand while damaging local production (the Growth Mismatch). Even as demand has remained robust, industrial production has stalled out during the past year. Output in May – the latest month for which we have data – was just 1.0% above the peak set in April 2010. During that same period, retail sales were up 8.2% in real terms.

And the impact on the broadest measure of activity – GDP – is also being seen. May’s GDP proxy released this past week was up only 0.17%M, the second-weakest sequential reading in the past year. Shouldn’t the damage to Brazil’s productive plant begin to feed through to hiring decisions and wages? We believe it is, but are not sure if it will be enough to tame inflation.

Let’s look at the recent signs of softening in labor markets. Although formal job creation was still a relatively healthy 150,000 seasonally adjusted in May, it is not nearly as strong as the 190,000 generated at the beginning of the year or the average of 185,000 during 2010. And real wage growth also appears to be slipping. Real wages rose on average 5.4% in 2H10 and 4.3% in the first three months of the year before slowing to 4% in May.

And while an uptick in inflation at the beginning of the year explains part of what has been happening to real wages, it doesn’t explain the full picture. Nominal wages are also slowing despite the powerful forces of indexation still present in the Brazilian economy. What’s behind all of this?

Domestic-focused enterprises have largely stopped providing positive real wage increases in recent months. Instead, the bulk of the high real wage settlements within the industrial base appear to be coming from commodity-related, large exporters. A growing wedge is being formed within Brazil’s industrial sector between commodity-related enterprises and more domestic-focused companies – that wedge is yet another manifestation of the Growth Mismatch. A strong currency is hurting domestic producers as imports are increasingly replacing local production.

At first glance, our findings that exporters are doing well might seem surprising to some. After all, if we argue that the strong currency has been a major factor harming Brazil’s industrial base, why then are exporters still able to pass on high real wages? We suspect that exporters are still in relatively good shape because strong export prices have helped to offset the damage from a stronger exchange rate. In contrast, domestic-focused, non-commodity-related industries are most likely being hit by the strong currency that has attracted import competition.

The damage to Brazil’s domestic-focused producers is reason for concern. We estimate that domestic-focused sectors make up for nearly 40% of Brazil’s manufacturing sector and manufacturing in turn makes up nearly one-fifth of all formal employment. But is this weakness among domestic-focused manufacturers enough to begin to work through demand channels throughout the economy? We are not sure.

The problem is that Brazil’s largest sector, services, appears to be gaining new entrants from the more troubled manufacturing sector. Broad services represent roughly half of formal employment, but have begun to gain share during the past year just as industry has begun to suffer. Unlike merchandise markets where strong demand can be met in part by growing imports, the most likely response in services to strong demand is simply higher prices and hence higher wage pressures.

While the service wage picture is mixed – we are seeing significant pressure in education services, domestic help, civil construction and ‘other services’, but not in financial or retail wages – the best-performing sectors account for almost 50% of GDP. And that likely explains why we are still seeing strong real wage growth.

If, as we expect, industrial output remains sluggish in Brazil, we would expect to see continued weakness in those sectors hit by growing imports. But it is not clear that this will self-correct and significantly reduce the Growth Mismatch as long as services remains robust and a benign external environment allows Brazil’s largest exporters to benefit from strong commodity prices.

Despite our global team’s recognition that the risks to the pace of the global recovery are rising, it is not clear that the global outlook will produce enough of a slowdown to cause a large enough correction in commodity prices to reduce increasingly sticky wage pressures in certain high-profile sectors in Brazil.

Bottom Line

The central bank appears to be preparing to end its hiking cycle. Whether it is one more hike (our view) or two more hikes (the view of many), the end may leave some puzzled. The good news is that the risk feared by many at the beginning of the year of inflation spiraling ever higher is highly unlikely. The bad news is that we expect inflation to be persistent for longer.

Brazil is facing a powerful wealth shock in the form of the strongest terms of trade in decades, which in turn is producing the strongest currency in decades. Unless the global economy turns down suddenly, we expect the strong currency to continue to have a powerful impact on consumer purchasing power.

And this means that while so much of the focus has been on what Brazil’s central bank will do next and how far it will move, the real challenge for Brazil is for the central bank to be joined by a much more concerted counter-cyclical fiscal policy. Brazil may be facing the challenge today from a Growth Mismatch, but structurally it continues to face a policy mismatch.

Source: Arthur Carvalho, Morgan Stanley (via Investment Postcards from Cape Town).

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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