by Win Thin
Brazil central bank meets Dec 7/8 and it will be the last meeting under Meirelles before he gives way to Tombini in 2011. No change this month is expected, but market is expecting the tightening cycle to start at the Jan 18/19 meeting. Besides the obvious need for higher rates, the thinking goes that Tombini will establish his independence and inflation-fighting credentials right off the bat by hiking at his first meeting. We have long felt that the market was underestimating tightening potential in 2011, but it appears to be coming around to our view. Weekly central bank survey shows market is now looking for an end-2011 policy rate of 12.25%, up from 12.0% last week and 11.75% last month. However, we continue to think that the rate could go as high as 12.75% next year from 10.75% currently.
Our reasoning for more aggressive rate hikes is the fact that even though the economy remains very strong, fiscal policy remains expansive. October data just released showed a much lower than expected primary surplus as well as a large nominal deficit (when a surplus was expected). Besides revealing her cabinet choices, the most important thing Rousseff must do is to rein in fiscal stimulus. This includes quasi-fiscal easing by development bank BNDES too. There is much spending in the pipeline due to the 2014 World Cup and the 2016 Olympics. As such, the brunt of the adjustment is likely to be borne by monetary policy. Market is looking for growth to slow to 4.5% next year from an expected 7.6% this year, but we think the risk is for something closer to 5.5% in 2011. With trend growth for Brazil thought to be around 4.0-4.5%, price pressures will continue to rise and that’s why we think tightening will end up being more than expected in 2011.
A more aggressive tightening path is likely to lead to more adjustments in the IOF tax, as the market appears to be in a sort of near-term “equilibrium” right now with policy rate at 10.75% and IOF tax at 6%. USD/BRL remains range-bound in the 1.70-1.75 area. We continue to believe that other FX measures will be rolled out on any significant break towards 1.65. As a result, we think that the year’s low around 1.6440 is unlikely to be tested anytime soon given what we see as increased Brazil risks as well as ongoing risk aversion that’s hitting EM overall.
