November 11, 2011

Brazil: The Real Structural Inflation Challenge (Guest Post)

By Arthur Carvalho of Morgan Stanley

For most of the year, inflation has been the biggest concern among investors, as many are worried that the upward trend would not be reversed. We have long argued that although Brazil has a serious inflation problem, it was exacerbated supply shocks last year and earlier this year that increased headline figures significantly. Although we have had only one inflation print that showed a decrease in yearly figures – October IPCA-15 declined from 7.3% to 7.1% – we believe that this is just the start of a trend. While this is certainly good news and should calm fears that inflation would run ever higher, this does not mean that Brazil’s structural inflation problem is over.

We think that the path needed to achieve significantly lower inflation on a structural basis is viewed as too costly by the current administration, which has very clear growth goals. This does not mean that Brazil will lose control of inflation, but it does keep the risk of inflation in the debate and reminds us a bit of Brazil’s more distant past.

Favourable Base

We agree with Brazil’s central bank that the decline in the October IPCA-15 is likely to be the first sign of a new trend. After slowing from 7.3% to 7.1% in mid-October, we expect October’s final reading (to be published on November 11) to show further softening to 6.9%. Although this year was full of negative surprises on the inflation front, and the recent monetary policy reversal into an easing mode does not inspire great confidence for the medium term, the yearly inflation prints should fall more than 150bp over the next few months due to base effects. Two technical factors are likely to be responsible for most of the reduction in headline figures, neither of which are expected to contribute to a structural slowdown of inflation.

First, as we have highlighted, a significant part of the late 2010 run-up in headline inflation was due to a shock in the beef supply chain, which alone contributed 60bp in the last three months of 2010. It is important to remember that this shock had little to do with international commodities prices, as Brazilian cattle are actually grass-fed. Given that beef supply is determined by the breeding pattern from two years prior, we can already forecast that a similar supply shock is very unlikely this year. Combined with some other factors, this should reduce headline inflation from the current 7.3% to 6.4% by December.

Second, in 2011 many administered prices were adjusted in 1Q, whereas these adjustments are typically spread out throughout the year. Next year is set to have a more balanced calendar that should help to lower inflation readings during 1Q, but most importantly, some adjustments will simply not happen in 2012. Given the municipal elections that are scheduled for 2012, we do not expect to see major changes in public transportation tariffs.

There are benefits from lower headline inflation in a country as heavily indexed as Brazil. Most contracts and wage negotiations are indexed to inflation from the previous 12 months, so a slowdown in headline inflation should reduce pressures to a certain extent. Although this signals that inflation is unlikely to spiral out of control, the lowest point in our forecast path is 5.5% in early 2012; this hardly serves as a signpost for a downward trend towards the centre of the central bank’s target of 4.5%.

Seasonal Pressures

Inflation will not be only good news, even over the next six months: sequential inflation is set to rise even as year-on-year inflation comes down. Even though we expect inflation prints measured on a year-on-year basis to fall, month-on-month prints on a sequential basis should increase from October until February due to seasonal factors. Over the next two months, the biggest risk factor continues to be ethanol prices, which are still rising and which we expect to increase due to a very poor sugar cane harvest season in Brazil. Nevertheless, the administration is taking a series of measures from tax breaks to importing corn ethanol from the US to avoid a pass-through to the consumer. Seasonality is not favourable to food prices, which tend to be pressured on the turn of every year due to the weather. The monthly prints should average around 0.45% in 4Q – including the October print which will be released November 11 and which we expect to be 0.40%. In addition, in 1Q12 we expect an average inflation clip of 0.70%, due to the schools’ annual adjustment and higher taxes on cigarettes.

Misdiagnosing the Problem

The real problem should not be forgotten. As much as we have argued that the jump this year in Brazilian inflation was misdiagnosed, we worry that the coming slowdown could also disguise the more fundamental issues. While a negative inflation trend could reassure the central bank that it is pursuing the right strategy by easing, we are afraid that underlying structural inflation is not showing signs of softening consistent with reaching the centre of the inflation target. The average of the three main core measures is at the year’s highest point, hardly signaling a downward trend. Another worrisome aspect is how widespread the process has become: although the diffusion index – the number of items that have a price increase divided by all items in the IPCA – is falling marginally, it is still very high by historical standards.

Brazil’s inflation problem, we believe, is directly linked to a tight labour market. Service inflation (which accounts for a quarter of the IPCA) is running at its highest level in a decade, and although we expect the labour market to have a mild correction over the next few months, the starting point is so tight that we still expect significant wage gains. Service inflation has the stickiest dynamics of all items in the IPCA due to the backward-looking nature of wage negotiations, among other idiosyncrasies in the Brazilian economy. This means that to bring inflation down requires a long period of sub-par growth. The silver lining is that as long as a tight labour market is the source of inflation pressures, inflation is unlikely to accelerate abruptly.

Based on the base effects and current evidence, we forecast that headline inflation will ease to around 5.5% by early 2Q12, after which it will resume an upward trend towards 5.9%. This expected path may keep inflation expectations relatively well anchored, given how sensitive these are to current inflation. Indeed, we are concerned that, for the next six months, the slowing inflation trend will lead many to think that the recent abrupt reversal in the monetary policy stance – from a hike in July to cutting rates in August – was appropriate. Another concern is the risk that a severe bout of weather could lead to an inflationary supply shock that could push inflation above the 6.5% upper limit of the target range, as long as service inflation is as high as it currently is.

Two questions arise from analysing the inflation structure and risks. Are the authorities counting on an excessively deflationary backdrop from abroad? Over the past year, the monetary authority has consistently said that Brazil’s inflation was partly the result of a strong spike in commodities prices, and that it expects these prices to be less of a problem over the next year. Although this is a sensible assumption, it highlights that the authorities are counting on external developments rather than promising action to keep inflation close to 4.5% in 2012. Our concern is that, given Brazil’s high level of indexation, whenever the authorities decide to tackle the underlying problems, the necessary effort will be larger, which leads us to the second question.

Will this administration ever take the steps needed to bring inflation down to 4.5% or even lower? Unfortunately, we do not believe so. Unless Brazil is hit with an exogenous deflationary shock, such as an abrupt fall in food prices, we do not foresee inflation returning to 4.5%. We forecast that service prices alone will contribute 2.5% to headline inflation in 2012, so even if goods and administered prices behave extremely well, it is unlikely that the other 75% of the IPCA will contribute only 2.0%.

In order to achieve lower inflation, the administration would probably have to allow higher unemployment for a prolonged period. The only period when Brazil actually reduced service inflation was in 2005, when it fell from 7.0% to around 5.0%. This was accompanied by several quarters of weak growth and rising unemployment, which broke the inertial wage dynamics.

We believe that the current inflation problem can be traced back to one of Brazil’s biggest achievements in recent history: a significant shift in income distribution. According to a study by Marcelo Neri from FGV, 30 million Brazilians have entered the middle class in the past eight years, generating important changes in domestic demand. While there is not one single factor that explains this expanding prosperity, the government’s efforts around social security, the minimum wage and social programmes are an important pillar. Although higher inflation can be partly attributed to a change in relative prices, we are concerned that the government is making a choice in the policy mix that will continue to lead to higher inflation than the 4.5% target.

Bottom Line

Neither the downturn in inflation’s year-on-year prints (due to a favourable base of comparison) nor the uptick in monthly inflation readings in the near term (due to seasonality) is an accurate reflection of Brazil’s inflation challenge. Brazil’s inflation problem is unlikely to get out of hand and does not make our list of top challenges for Brazil. However, the recent handling of inflation is likely to create some uncertainty over the commitment to Brazil’s inflation target and in turn has likely taken a problem that once had been viewed as resolved and resurrected it as an issue of investor concern.

Courtesy Arthur Carvalho, Morgan Stanley, November 8, 2011 via Investment Postcards from Cape Town. (EconMatters author archive here.)

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

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