Brazil Raises Benchmark Interest Rate By 50 bps To 10.50%, More Than Expected

The rest of the world may be stuck importing Japan's deflation (and Europe may be even contemplating launching a Fed type QE as BNP suggested first some time ago), but one country is doing all in its power, and more, to slow down hot money and the resulting inflation - Brazil. Moments ago the Central Bank of Brazil raised the Benchmark Selic interest rate by 50 bps points more than the 25 bps expected, to 10.50%.

From the press release:

Brasília - Continuing the adjustment of the basic interest rate process, initiated in April 2013 meeting, the Committee decided unanimously, at this time, to raise the Selic rate by 0.50 percentage points to 10.50%, with no bias.

This is how Brazil's interest rates have looked in the past 6 years:

While this decision will catch most forecasters by surprise, and will hardly please Bovespa investors, this is what Goldman had to say about the decision earlier today:

Recent Dovish Remarks Suggest a +25bp Selic Hike Today but Sticky Inflation Increases Probability of a Deeper and Longer Hiking Cycle

The Monetary Policy Committee (MPC; Copom) meeting will take place later today. Given the dovish central bank undertones contained in both the minutes of the Nov 27 Copom meeting and the subsequent Quarterly Inflation Report (QIR), we expect the Copom to moderate the magnitude of rate hikes to +25bp (following five consecutive 50bp hikes). However, given the pressure on the BRL, the December IPCA inflation surprise (which frustrated the central bank's public commitment to deliver inflation in 2013 below the 5.84% level of 2012), and the stickiness of headline, core and inflation expectations, we assess at least a 40% probability of another +50bp hike tonight. Furthermore, we do not rule out that, consistent with the recent more dovish remarks, the Copom does indeed moderate the pace of hikes to just 25bp but hints (likely indirectly) that the tightening cycle will continue at least until the February 26 meeting.

The outlook for inflation remains challenging. Inflation dynamics seem to have deteriorated towards the end of 2013. Altogether, very little progress, if any, was recorded during 2013 to re-anchor inflation to the admittedly generous but still elusive 4.50% inflation target. Overall, headline IPCA inflation ended 2013 at a high 5.9% (5.91% for two-decimal precision), exceeding the already high 5.84% 2012 print, despite having benefitted from: (1) the mean-reversion throughout 2013 of the large 2012 food supply shock; and (2) a very significant positive administered-price supply shock (see below for a more detailed discussion). In all, ultimately the monetary authority was not able to deliver even on the admittedly undemanding commitment to have headline inflation ending 2013 below the 2012 level.

In short, inflation remained high and generalized over the past year. Furthermore, key inflation measures ended 2013 at a higher level than in 2012. For instance, the average of the three main core inflation measures—smoothed trimmed means, double weight, and ex-food and regulated prices—accelerated to 6.1% yoy at year-end 2013 from 5.8% in 2012. In addition, services inflation remained high: 8.7% (unchanged from 2012; a reflection of, among other factors, inertia and unanchored inflation expectations). Furthermore, tradable inflation accelerated to 6.0% in 2013 (from 4.5% yoy a year ago, driven in part by a weaker BRL) and non-tradable inflation ended 2013 at a high 8.45% yoy; down from 9%-plus at mid-year but higher than the 8.38% print at year-end 2012. Finally, year-end 2014 inflation expectations have deteriorated steadily since March 2013 and are significantly misaligned from the target.

Not only did headline/core inflation end the year at unacceptably high above-target levels, but there is now also a high level of repressed inflation in the system (via regulated prices/tariffs) that will render the task of disinflating the economy harder in the years ahead. For instance, inflation among the items whose prices are freely determined/set by the market (prices determined by supply and demand in the market; 75% weight in the IPCA) ended 2013 at a high 7.3% yoy (up from 6.5% in 2012), while inflation in prices that are regulated by the government (25% weight in the IPCA) ended the year at a low and unsustainable 1.5% yoy (down from 3.7% in 2012 and the lowest level since at least 2004). That is, had regulated price inflation ended 2013 at the same already relatively low 2012 level, headline inflation would have ended 2013 at or above 6.5% upper limit of the IT band.

In our assessment, the wide 578bp gap between inflation in freely determined and administered/regulated prices will have to normalize in 2014-15 to avoid further micro and macro distortions in the economy (e.g., misallocation of resources and weakening balance sheets of the companies operating in regulated sectors). Overall, we believe the government strategy of fighting inflation by managing regulated prices and the exchange rate rather than by addressing its underlying root causes has proven ineffective and no substitute for conventional demand management policies (fiscal and monetary). In fact, this strategy may have contributed to delaying a timely and decisive monetary policy response to the rising inflationary pressures. This contributed to the significant generalization of inflationary pressures and strengthening of inertial forces, which will ultimately increase the output cost (sacrifice ratio) and length of time required to disinflate the economy.

The estimated density function of freely determined prices has moved to the right compared with a year ago. The center of the headline IPCA inflation distribution does not appear to have shifted much from a year ago, but by year-end 2013 the density function (1) developed a fatter right-tail (i.e., skewed to higher inflation outcomes); and (2) seems to have turned bi-modal, possibly a reflection of the widening gap between freely determined and administered prices. Replicating the same exercise with just the subset of freely determined prices shows a clearer rightward shift of the inflation density function from year-end 2012 to year-end 2013 with the distribution now centered outside the 6.50% upper limit of the inflation target band. Furthermore, the bi-modal characteristic of the headline IPCA density function disappears when we exclude regulated prices.