Banco Central do Brasil to cut rates further as inflation falls towards target

Inflation in Brazil rose sharply in 2021 leading the BCB to raise the Selic rate from 2% to 13.75% in the space of 18 months. The rapid tightening of monetary policy helped bring supply and demand into better balance, allowing the central bank to begin cutting interest rates in the second half of 2023.

In February, Extended National Consumer Price Index (IPCA) inflation fell to 4.50% year-on-year from a peak of 12.13% in April 2022. This brought headline inflation back within the BCB’s target range, which was reduced by 0.25% in 2024 to pursue IPCA inflation between 1.5% and 4.5% (3% +/- 1.5%) (see Chart 1).

Chart 1. Brazilian inflation and inflation expectations (% change, year-on-year)

Source: LSEG Data & Analytics, Banco Central do Brasil and EFGAM calculations. Data as at 13 March 2024.

The largest contribution to February’s inflation print came from education, with many schools and universities raising fees ahead of the start of the academic year in February.¹ Food and beverages prices also made a significant contribution, with rising food prices reflecting the impact of El Niño on agricultural production.²

The BCB will take some comfort in the temporary nature of these inflationary pressures. The inflation data are not seasonally adjusted and the increase in education fees is highly unlikely to be repeated until February 2025, meaning it will add little upward pressure to annual inflation rates in the next 11 months. In addition, the Monetary Policy Committee (Copom) has already incorporated food price increases due to the El Niño phenomenon into its projections.³ Copom expects inflation to average 3.5% in 2024 and 3.2% in 2025 as the lagged impact of restrictive monetary policy weighs on demand.

As shown in Chart 1, markets also expect inflation to decline towards the target range over the course of 2024. The BCB monitors market expectations through its ‘Focus Survey’ to gauge sentiment on a number of macroeconomic variables.⁴ While it will be of some satisfaction that inflation expectations at 3.8% for 2024 are similar to the BCB’s projection, the central bank has highlighted concern about longer-term inflation expectations being partially unanchored. Markets expect inflation to average 3.5% every year from 2025 to 2028, above the BCB’s central target. Thus, the BCB is likely to maintain a restrictive policy stance until inflation expectations converge fully to the 3% target. It is worth nothing that inflation expectations are often influenced by current inflation prints meaning expectations could converge to target in tandem with inflation.

The International Monetary Fund expects Brazil’s gross domestic product (GDP) to grow 1.7% in 2024, slowing from the 2.9% expansion registered in 2023.⁵ However, at its January meeting, the BCB highlighted the potential for economic activity to be bolstered by an increase in the minimum wage which in turn would support domestic demand.⁶ Furthermore, the resilience of the US economy and the potential for China to grow at a similar rate this year as last could also support Brazil’s GDP growth as these are Brazil’s main trading partners.⁷ Although the BCB still expects economic activity to slow, Purchasing Managers' Index (PMI) data so far this year point to upside risks to this view (see Chart 2).

Chart 2. Brazil’s output PMIs (diffusion index)⁸

Source: LSEG Data & Analytics. Data as at 13 March 2024.

With these factors in mind, it seems logical that the BCB maintains a restrictive monetary policy stance, as it has indicated. Despite this, there is room for interest rates to decline. Copom has cut rates by 50 basis points in each of its five meetings since August 2023 leaving the Selic rate at 11.25%. The minutes of its January meeting highlighted that “Committee members unanimously anticipate further reductions of the same magnitude in the next meetings”.

Markets expect the Selic rate to fall to 9% by the end of 2024 and 8.5% by the end of 2025 (see Chart 3). If both inflation and interest rates decline as markets expect, this would roughly equate to a 155 basis point decline in the real Selic rate this year and a further 20 basis point decline next year. In this scenario, the real Selic rate would be around 5% at the end of 2025.⁹ Recent estimates of the neutral real Selic rate range from 2% to 4.8%, meaning this would still be considered restrictive.¹⁰

Chart 3. Market expectations for the end-of-year Selic rate (%)

Source: Banco Central do Brasil. Data as at 13 March 2024.

In summary, inflation in Brazil is expected to decline over the course of the year but long-term inflation expectations remain partially unanchored and the BCB is therefore likely to retain a restrictive monetary policy. Nonetheless, the fact the real Selic rate is 6.75% means the BCB can reduce rates while keeping policy restrictive. Thus, market expectations for a further 225 basis points of rate cuts in 2024 and 50 basis points in 2025 appear well placed.

¹IPCA inflation rose 0.83% month-on-month in February. Education and food and beverages contributed 0.29 and 0.20 percentage points respectively to this.
² El Niño’ is a climate pattern that describes the unusual warming of surface waters in the eastern Pacific Ocean, affecting ocean currents and local weather from Australia to South America.
³https://go.pardot.com/e/931253/en-publications-copomminutes/41111i/343030575/h/fKr10CaKM66Sm7Kvbunv07Z6AisA5u6YgmxTrrbGrzY
⁴https://go.pardot.com/e/931253/etarypolicy-marketexpectations/41114i/343030575/h/fKr10CaKM66Sm7Kvbunv07Z6AisA5u6YgmxTrrbGrzY
⁵https://go.pardot.com/e/931253/ic-outlook-update-january-2024/41117i/343030575/h/fKr10CaKM66Sm7Kvbunv07Z6AisA5u6YgmxTrrbGrzY
⁶ The minimum wage in Brazil was raised by 7% from BRL 1320 per month to BRL 1412 per month on 01 January 2024..
⁷ See EFGAM Macro Flash Note, ‘Outlook for Brazil and Mexico still supportive for equities in 2024’ (December 2023)
⁸A purchasing manager’s index (PMIs) score above 50 represents an expansion, while a score below 50 represents a contraction and a score of 50 indicates no change relative to the previous month.
⁹ The actual real rate at the end of a year will depend on the profile of monthly inflation throughout the year. For example, if markets expect average inflation of 3.5% in 2025, this could be achieved with 3.5% inflation over 12 months or with 4% inflation for 6 months followed by 3% inflation for 6 months. If the Selic rate is 8.5% at the end of 2025, the former inflation profile would result in a real rate of 5%, while the latter would result in a real rate of 5.5%.
¹⁰ https://go.pardot.com/e/931253/rbfin-article-view-82751/4111f/343030575/h/fKr10CaKM66Sm7Kvbunv07Z6AisA5u6YgmxTrrbGrzY
https://go.pardot.com/e/931253/y-in-the-Post-Inflation-Period/4111j/343030575/h/fKr10CaKM66Sm7Kvbunv07Z6AisA5u6YgmxTrrbGrzY
https://go.pardot.com/e/931253/nreport-202306-ri202306b6i-pdf/4111m/343030575/h/fKr10CaKM66Sm7Kvbunv07Z6AisA5u6YgmxTrrbGrzY