Colombia
Front-Loading Rate Cuts
February 04, 2009

By Boris Segura | New York

We have argued for a rate cut cycle of 200bp, starting in 2009 (see “Colombia: Rate Cuts Coming”, EM Economist, December 19, 2008), to 8% by the end of the year.

A lot has changed since then. To begin with, Banco de la Republica unexpectedly cut 50bp at its last monetary policy meeting of 2008, and central banks across the region (Brazil, Chile and Mexico) began 2009 cutting rates faster than expected. And just on January 30, the Colombian central bank cut its intervention rate again by a further 50bp, with some members pushing for a larger dose of monetary easing.  Furthermore, economic activity indicators for Colombia have been soft, and inflation expectations are rapidly converging to Banco de la Republica’s (higher) target.

We now see room for a more ambitious monetary policy easing. We expect the year-end intervention rate to close at 6%. We’ll explore why in this brief note.

Activity Softening

Our economic growth forecast for 2009 was initially viewed as too bearish when we published it originally in October (2%), and even more so when we downgraded it further to 1.5% last December. However, slowly but surely consensus has been catching up to our forecast.

A battery of high-frequency indicators are showing continued weakness. Industrial production, retail sales, consumer and business confidence, as well as labor market trends have been on a downward spiral for most of 2008.  While this softness was an intended consequence of Banco de la Republica’s tightening campaign that ended in July 2008, there is a growing sense that the economic pain abroad, not only in the US but in neighbors Venezuela and Ecuador, is taking a major toll on export-oriented activities in Colombia. If anything, there is downside risk to our GDP growth forecast.

Inflation Approaching New, Higher Target

As Banco de la Republica raised its inflation target in 2009 to 5% (from 4%), it is now easier to hit its target. 12-month ahead inflation expectations are already within striking distance of the new inflation target. Even our favorite measure of core inflation (nontradables inflation excluding food and regulated prices) is now safely inside the central bank’s new target.

The central bank is confident that headline inflation, which closed 2008 at 7.7%, will converge to its target this year. In the minutes of December’s monetary policy meeting, the authorities argue that a weak domestic economy and world disinflation (absent pass-through from currency depreciation) will reduce inflation pressures in Colombia. This logic was reaffirmed after the last monetary policy meeting. We made a similar argument earlier (see again “Colombia: Rate Cuts Coming”, EM Economist, December 19, 2008), but were expecting monetary authorities to begin cutting rates once headline inflation convincingly reversed course, and core inflation and inflation expectations began to come in below the new target.

New Rate Call

We now expect Banco de la Republica to cut its intervention rate to 6% in 2009. The intervention rate in real terms would quickly fall and monetary policy would switch into ‘stimulus territory’.

We suspect that the rate cuts will be front-loaded in the first half of the year. As doves might now form a majority in Banco de la Republica’s board, it is likely that the central bank abandons the gradualism it displayed when tightening monetary policy since 2006 and instead goes for quick doses of 50bp cuts going forward. During the last monetary policy meeting, there were members already pushing for rate cuts larger than 50bp.

In the end, we wouldn’t count on a major impact from monetary easing. As we envision shaky consumer and business confidence, a weaker labor market and a worsening in banks’ asset quality, it is unlikely that this monetary stimulus will translate into faster credit growth.

Bottom Line

We now forecast Banco de la Republica’s intervention rate to end 2009 at 6%. And we suspect that monetary easing will be front-loaded in the first half of the year. But don’t expect a quick economic recovery, as Colombia’s economy is facing several headwinds; at best, easier money is only likely to cushion the blow.

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Brazil
Monetary Policy − The Big Ease?
February 04, 2009

By Marcelo Carvalho | Sao Paulo

Brazil has now joined the global monetary easing cycle, with a larger-than-expected initial rate cut, followed by dovish policy signals. In light of this aggressive policy action and subsequent dovish COPOM minutes, we are cutting our interest rate forecast. We now assume a full easing cycle of 400bp (from 200bp before). We look for three consecutive rate cuts of 100bp each, on top of January’s initial 100bp cut already implemented. The policy rate would fall to 9.75% by mid-2009 (from 11.75% in previous forecast), and stay there through year-end. 

This would be the first time that Brazil’s policy rates fall to single-digits in recent history. Sadly, aggressive cyclical easing does not guarantee a structural shift to permanently lower real interest rates. Monetary easing supports the case for growth recovery in 2H09, but it does change our below-consensus forecast of zero average real GDP growth in 2009, given a weak start for the year. 

COPOM: Aggressive Action, Dovish Signal

Last week’s COPOM minutes were dovish and consistent with the recent decision to start the monetary easing cycle aggressively, with a larger-than-expected rate cut of 100bp on January 21. Essentially, the minutes underscore the recent sharp growth downturn and show less concern about inflation pressures. The minutes recognize the dramatic global growth deceleration and Brazil's own recent slowdown – although partially exacerbated by an inventory correction.  Importantly, the net impact from global events on Brazil's inflation is now described as predominantly “benign” – a month ago, it was still “ambiguous”. 

The growth outlook has worsened. The COPOM minutes provide no numerical forecast for real GDP growth. However, in our opinion, the growth environment facing the COPOM has surely deteriorated from the 3.2% average real GDP growth projection for 2009 shown in the central bank's latest quarterly inflation report, as of last December. The market consensus forecast for 2009 growth has since fallen towards below 2%. We continue to look for zero growth in 2009.

The minutes argue that domestic demand slowdown should reduce inflationary pressures, and underscore that inflation expectations are coming down. Remaining upside risks for inflation include: currency devaluation and feedback inflation mechanisms. Still, inflation risks are now “reduced” – before, they were “relevant”. In fact, the minutes underscore the “lack of clear evidence of inflation pass-through from currency devaluation”. 

The minutes also revise down the central bank's projections for inflation. Under a reference scenario assuming stable currency and interest rates at current levels, the central bank's projection for 2009 IPCA inflation fell from a month ago. No precise numerical forecast is provided in the minutes – only in the quarterly inflation report. But the 2009 projection now stands “below” the 4.5% official target center, from “above” the 4.5% mark a month ago. Likewise, the 2010 inflation projection also declined, and now stands “appreciably” below the 4.5% target.

COPOM says little about size of full rate-cutting cycle, but gives some clues on the pace of easing. The COPOM minutes provide no elaboration on the previous policy statement at the time the decision was announced that the initial rate cut of 100bp should already prove a “relevant part” of the full easing cycle. As for the pace of upcoming rate cuts, the minority three board members (out of eight) that voted for a smaller 75bp cut argued that “a more moderate rate cut would provide a signaling more consistent with the prospective convergence trend of inflation towards the inflation target, and would better correspond to the optimal pace of monetary easing”. In other words, a minority in the board seems to think that 75bp is a better pace of easing, rather than the actual 100bp rate cut. 

In a dovish tone, the minutes boost the case for further monetary easing ahead. After all, as recently as at the December policy meeting, board members had discussed whether to start the easing cycle with a 25bp rate cut, but in the end decided unanimously to keep rates unchanged. A month later, the policy debate changed radically, with board members now discussing whether to cut 75bp or 100bp, finally opting for the latter. Several significant changes in the January minutes reveal a major change in the authorities’ perceptions about the macro environment facing the Brazilian economy. 

Reducing our Rate Forecast

We are cutting our interest rate forecast in light of recent aggressive policy action and latest dovish policy signals. We now look for full rate-cutting cycle of 400bp (from 200bp before), with a total of four consecutive rate cuts of 100bp per meeting. So, besides the January initial rate cut already in place, we look for three additional consecutive rate cuts of 100bp each (in March, April and June). The policy rate would therefore fall to 9.75% by mid-2009, and stay there through the rest of the year.

Recent policy statements should not be seen as necessarily imposing a hard limit on the size of the full easing cycle. The authorities have indicated that the initial rate cut of 100bp should already prove a “relevant part” of the full easing cycle. But the last time the central bank used such front-loading language, it ended up having to do much more than it initially planed. Indeed, in April 2008, the COPOM launched a monetary tightening cycle with a larger-than-expected 50bp rate hike, and argued that such initial move should prove a “relevant part” of the full cycle. Later on, the COPOM was forced to accelerate the hiking pace to 75bp. The full tightening cycle ended up at 250bp – and heading for even more, if it were not for the global turmoil. In all, we believe that the central bank will again prove pragmatic, adapting policies according to evolving macroeconomic conditions. 

We assume an easing pace of 100bp per meeting. True, the January COPOM minutes indicate that a minority in the board thinks that 75bp is a better pace of easing, rather than the actual 100bp rate cut. However, by the next meeting, on March 11, poor growth data will likely provide further ammunition for the majority of doves. While it is possible that COPOM eventually slows the easing pace (to individual moves of 75bp or 50bp, say), an escalation to individual cuts larger than 100bp would likely require a much bleaker growth environment. 

If our new forecast materializes, the policy rate would fall into single-digit territory for the first time in Brazil’s recent history. A look at previous easing cycles in Brazil provides interesting comparisons. First, the current cycle would prove relatively short, as it would take just six months for policy rates to drop from peak to trough. Second, a nominal absolute cumulative full rate cut of 400bp does not look particularly large compared to previous episodes. Third, the starting and ending points for the absolute level of nominal rates are now lower than ever before – which, in turn, helps clarify the second point just mentioned above.

One unusual aspect about the current easing cycle is that rates fall despite currency devaluation. In particular, monetary easing is possible because inflation expectations are well behaved. Indeed, unlike in previous episodes, market expectations for 12-month-ahead IPCA inflation have not jumped much, despite sharp currency devaluation in 2H08. 

Where did the currency pass-through go? As the central bank correctly points out, there is no clear evidence of inflation pass-through from currency devaluation in the inflation data. Is the pass-through dead, or just dormant? We still lean towards fearing the latter. Given the magnitude of the currency move, it would be surprising if there is absolutely no pass-through to inflation indefinitely. Most estimates of the historical currency pass-through coefficient in Brazil typically sit in the range of 5-10%. To be sure, Brazil faces collapsing international commodity prices, global disinflation, sharp growth downturn, weak pricing power and deep discounts to reduce excessive inventories. So, the pass-through coefficient this time around indeed should be much smaller than ever before. But we are not yet convinced that the pass-through is zero, and so we suspect that inflation might still turn out higher than expected, later on. Still, we admit that growth recession reduces inflation risks, at least for the immediate future. 

In all, growth concerns look set to remain the over-riding driver for COPOM decisions over the next several months. Looking further ahead, the 2010 outlook is a long shot at this stage. But we suspect that the COPOM may eventually have to increase rates again at some point next year, as the economy regains traction while global inflation and monetary conditions start to normalize.

How low can real rates go? Brazil’s real interest rates have been broadly in high single-digits during recent quarters, although the exact number depends on the specific measurement – observers often compare the policy interest rate against either past inflation of expected future inflation, or else look at the one-year market interest rate against 12-month-ahead inflation expectations. As COPOM eases further, real rates can fall in coming months, in an emergency cyclical response to growth recession. 

But we suspect that cyclical monetary easing is different from a steady march to sustained, structurally lower real interest rates. In particular, we fear that Brazil’s policy mix remains unbalanced. Loose fiscal policy probably helps explain why, historically, interest rates have been abnormally high in Brazil. In other words, we fear that structurally sounder fiscal policies are needed before Brazil can truly enjoy structurally lower real interest rates on a sustained basis. In all, Brazil’s real interest rates hopefully should trend lower over the years. But this process is likely going to be a bumpy road, rather than a straight line or a sudden permanent jump.

Risks to the Rate Outlook

What could constrain the central bank’s ability to cut rates? First, there is a risk of rising country risk perceptions – let’s say, on the heels of policy mistakes amid falling global risk appetite and shrinking capital flows into emerging market economies.

Second, a combination of further currency weakening and resurgent pass-through to inflation could complicate the central bank’s ability to reach its inflation goals. 

Third, rising food price inflation could still prove a thorn in 2009. After all, Brazil’s grain harvest is bound to take a significant hit this year. That is a result of recent bad weather in the south of the country, as well as lower yields as credit-constrained farmers have used much less technology (pesticides and fertilizers) in the latest planting season. Last, but not least, if the economy rebounds sooner and more strongly than anticipated, the case for aggressive monetary easing would weaken. 

Conversely, what could lead the COPOM to cut rates by even more than expected? A first good candidate is the growth outlook. Our global economics team looks for a global recovery into 2010, and our Brazil forecast assumes a sequential growth recovery in 2H09. If recession proves more prolonged than expected, the case for further monetary easing would gain ground. 

Second, and related to the first point, global monetary policy matters too. Brazil’s recent aggressive rate cut fits a broader pattern seen elsewhere around the globe lately, where central banks surprise with larger-than-expected rate cuts. Further aggressive global monetary easing might well facilitate bolder moves by Brazil’s central bank. 

Third, on the inflation front, a cut in domestic gasoline prices can help too. We (and the central bank) assume no change in gasoline prices this year. International gasoline prices currently stand about 30% below (regulated) domestic gasoline prices, at the refinery level. Full equalization of domestic gasoline prices with international levels could trim about 0.7pp from IPCA consumer price inflation. 

Implications for Investors

First, our new forecast for a rate cutting cycle of 400bp is more aggressive than the 250-300bp priced in the local yield curve lately. 

Second, concerns on risk premia can eventually weigh on the longer end of the curve, arguing for curve steepeners. 

Third, long-dated inflation-linked bonds may offer value.  Breakeven inflation has traded below the 4.5% inflation target in recent weeks, at least until recently. That seems odd – even if inflation falls below target in the near term, then the policy rate would tend to decline over time, in turn, pushing inflation back towards the target over the years.  That said, weak growth data and relatively benign inflation readings could still keep implicit breakeven inflation low for a while. 

The new rate forecast does not alter our bearish view on growth. Monetary easing should help support growth recovery in 2H09. But we are skeptical that it will be enough to shield Brazil from powerful global headwinds. In fact, the global shock has already pushed Brazil’s sequential growth well into negative terrain in 4Q08. In all, swings in the growth path through 2009 could prove more pronounced, with a weaker start and a better finish than first assumed. But this does not change our long-standing, below-consensus view that average real GDP growth in Brazil will be zero in 2009. 

Bottom Line

We are cutting our interest rate forecast, in light of recent aggressive policy action and dovish signals. We now assume a full easing cycle of 400bp (200bp before), with three consecutive cuts of 100bp from here. The policy rate falls to 9.75% by mid-2009 and stays there through year-end. Such path can create investment opportunities for fixed-income investors. But monetary easing does not change our below-consensus view on growth.

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