klaser "The Great" wrote: If the US doesn't tank Brazil takes off this year,if the US tanks Brazil will not do as bad as the rest of the world
Brazil: As Good As Inflation Gets?
February 06, 2007
By Gray Newman | New York
After posting one of the lowest annual inflation readings in more than half a century, many Brazil watchers think the inflation picture is as good as it gets. We disagree. If anything, we suspect that in the coming months we may be required to lower our inflation forecast of 4.1% for the year, and that the market will follow.
Our bullishness on Brazil’s inflation success doesn’t mean that Brazil cannot see cyclical pressures on inflation again. But the kind of upturns that wreaked havoc on Brazil for decades — and most importantly, which still appear to be responsible for some of the pricing in the yield curve — are simply unlikely to stage a return, in our view. Brazil’s traumatic inflation experiences of the past belong in the history books, not in Brazil’s yield curve.
First, however, let’s review the arguments of the naysayers.
Up, up and away
The position of the inflation naysayers does have some merits. After all, history has not been on the side of those calling for inflation to beat the near record set this past year. With the exception of the bout of deflation in 1998 when the authorities were burning through tens of billions of dollars in reserves to try to maintain a fixed exchange rate, one has to go back to the 1940s to find a year-end inflation reading close to the 3.1% posted in 2006. We had to use Sao Paulo’s inflation measure in the 1940s, since Brazil did not even have a national inflation measure at the time.
Furthermore, the 2006 inflation reading likely exaggerated the drop in inflation last year. Measures of core inflation vary, but the average of the three most commonly cited by the central bank suggests that core inflation ended last year somewhere between 3.6% and just over 4%, in contrast to the headline report of 3.1%. A bout of food deflation helped to explain most of the gap between headline and core measures of inflation. Even if inflation remains stable in 2007, the naysayers note, headline numbers are likely to trend closer to 4% than to 3.1%.
With Brazil showing signs of economic activity and domestic demand gaining pace, the risk is tilted towards higher inflation, the naysayers add. While the economy has grown by less than most expected in 2006, most Brazil watchers expect to see the improvement in 2H06 gain ground in 2007. Retail sales, which grew on average by 6.1% in the 12 months through November, picked up pace in 4Q, with growth of nearly 7% in October and 9.2% in November.
Finally, the naysayers point to relaxation on the fiscal front as a warning sign on the inflation front. While the growth acceleration pact announced on January 22 was vague, it offered room for extra spending of up to 0.5% of GDP; if fully executed, this could produce Brazil’s smallest primary surplus (3.75% of GDP) in the past five years. And the implications seem clear for monetary policy: the central bank has warned that fiscal stimulus might produce a level of demand growth which would limit the central bank’s ability to ease rates in every set of minutes of the Copom since March 2006.
The death of inflation
We’d highlight three problems with the school of thought that argues that Brazil’s inflation performance in 2006 was as good as it gets. First, we are skeptical of the argument that stronger demand is likely to produce greater inflationary pressures in 2007. As we have seen around the globe, the traditional macro relationships between output gap and inflation are much weaker today than in the past. Globalization has driven a wedge between the old links between labor costs and inflation, the output gap and inflation and that of import prices as well.
As economies have opened up, the traditional relationships are simply not as strong as import competition plays a new, more powerful role in price-setting. We are not arguing that there is no relationship between stronger domestic demand and inflation, but only that the relationship is much weaker in Brazil today when total trade as a percentage of GDP is closer to 38% than in 1995, when total trade was close to 17% of GDP. Indeed, the most recent test of the link between stronger domestic demand and inflation suggested that the relationship was negative: inflation slowed in the second half of the year even as domestic demand gained ground.
Second, we are just as skeptical of the claim that fiscal stimulus represents a significant threat to inflation. In 2006, Brazil’s primary surplus fell from 4.8% in the previous year to an estimated 4.3% as election spending, cash transfers via Bolsa Familiar and higher pension outlays brought on by a minimum wage hike were felt. Yet, again, the trend was towards lower inflation still. In 2007, the stimulus, if the full amount outlined under the growth acceleration pact (0.5% of GDP) is actually executed, would be roughly the same, with primary spending declining from 4.3% to 3.75%.
Third, we suspect that there is room for further disinflation in the months ahead. While it is true that Brazil has rarely seen inflation below 4% and is also true that most measures of core suggested that the headline result in 2006 might have exaggerated the improvement, we suspect that the downward trend is not over.
When we break inflation into tradable, non-tradable and administered components, we see that tradable inflation has been leading the disinflationary trend in recent years. In fact, in large part due to exchange rate appreciation, tradable inflation ended 2006 near 1.3%. While we don’t expect the Brazilian real to continue to gain in nominal terms, we suspect that it will remain strong and is unlikely to produce a bout of weakness that would feed through to inflation. Meanwhile, with backward-looking administered prices likely to slow further as they benefit from past exchange rate-induced disinflation, they are unlikely to produce an uptick in 2007. And with non-tradable inflation (near 4%) higher than tradable inflation, we suspect that consumers are likely to continue to switch, on the margin, from non-tradable to tradable consumption. That move, similar to a negative demand shock for non-tradables, could pressure non-tradable inflation down further. Indeed, just such a move downward in non-tradable prices is already taking place. This would suggest that part of the improved domestic demand could contribute to more demand for tradables — where import competition is greater — relative to non-tradables.
On cycles and structural breaks
We aren’t arguing that inflation in Brazil is immune to business cycles or stimulus from the fiscal or monetary authorities. We are simply arguing that the traditional relationships so often cited by the central bank and by most Brazil watchers appear to be weaker today. We aren’t claiming that the episode of 2006 in which domestic demand gained ground even as inflation — with or without food, core or headline — dropped is proof that an upturn in demand leads to lower inflation. But only that the relationships are likely to be much weaker.
Cycles may be alive and well in Brazil, but their impact on inflation has likely declined thanks to Brazil’s greater openness to international trade, as well as to the prudence on the fiscal front and the central bank’s work at strengthening its credibility. Of course, we may be wrong and cyclical pressures may cause an inflation upturn if demand is not satisfied by domestic production or imports or if the fiscal stimulus is much larger than we are predicting. But Brazil’s yield curve — with rates still hovering above 12% a year from now — seems to be pricing in much more than a cyclical upturn.
Bottom line
It is perhaps too early to call for the death of inflation in Brazil. But even after stripping out the benefits from food deflation in 2006, last year’s slowing in inflation even as demand regained ground and fiscal contraction was eased should serve as a warning sign to those who expect inflation to turn up in 2007. At present, many Brazil watchers seem to be working with the assumption that the only inflation surprise in Brazil in 2007 is likely to take the form of inflation coming in higher than expectations. We would argue just the opposite.
Cycles may not be over, but they are likely to prove less potent today than in the past in determining inflation. Meanwhile, one would never know this from looking at Brazil’s yield curve. While there is a legitimate debate on whether inflation ends 2007 at 3% or 3.5% or 4%, Brazil’s yield curve still appears to be reflecting the trauma of battles of the last decade. That battle appears to have been won.
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