Brazil Central Bank’s Historic Easing Faces Drawbacks Ahead

(Bloomberg) — Political consensus helped Brazilian central bank chief Roberto Campos Neto slash interest rates to a record low last year. It’s a different story in 2020.

As the bank looks to continue with the easing cycle amid prospects of a deep recession in Latin America’s largest economy, the always volatile world of Brazilian politics have now become a red light for Campos Neto, limiting the scope for aggressive reductions and driving traders to predict the central bank will have to reverse course as early as December.While most analysts expect policy makers to cut the Selic rate by half a point on Wednesday to 3.25%, the road ahead has turned increasingly murkier after a change in the political outlook.

Just two weeks ago, most traders expected the central bank to cut by 75 basis points at this meeting and start raising rates only in March, taking the Selic to 4.75% by the end of 2021. Now they bet policy makers will be forced to hike as early as December, and that borrowing costs will reach at least 5.75% by the end of next year.

Yet recent political turmoil, including criminal allegations against President Jair Bolsonaro and doubts about the economic team headed by Paulo Guedes, are leaving last year’s relative congressional harmony behind. While not precluding additional rate cuts in the short term, the crisis will probably force Campos Neto to be much more cautious with his next steps.

“We are in a perfect storm with the departure of important ministers and the economic area in the midst of tension. There’s a lack of understanding between branches of government and that creates uncertainty,” former central bank chief Arminio Fraga said in an April 30 webcast. “The central bank signaled it will cut rates, but the long end of interest rate futures has been rising.”

The central bank will publish its key rate decision on its website together with a statement after 6:00 pm local time on Wednesday. Eight of 37 economists in a Bloomberg survey still expect the bank to go ahead with a 75 basis-point reduction.

Political Minefield

The central bank has repeatedly nodded to politics by saying the advance of austerity measures negotiated with Congress is key in reducing rates and keeping them low. Despite some bickering, lawmakers moved in lockstep last year when they approved Bolsonaro’s proposal to cut billions of dollars in pension spending.

Brazil’s political landscape has since become a minefield, as a spat with lower house Speaker Rodrigo Maia, mounting criticism over the government’s coronavirus response and the departure of Justice Minister Sergio Moro left Bolsonaro playing a defensive strategy. At the same time, he’s come under intense pressure to boost public spending even if it leads to the departure of Economy Minister Paulo Guedes, an investor favorite.

Read More: Brazil’s Economy Chief Fights Back to Keep Control Over Budget

Political risk reared its head on Tuesday, when the lower house approved a multi-billion dollar package to help states and municipalities amid the coronavirus outbreak, but altered a condition negotiated by Guedes that would freeze salary increase for civil servants.

Those tensions have hastened a world-leading plunge in the real, which smashed through its own record low on April 27. That drop stands to bring its own set of problems, as a weaker currency may fan inflation by making imports more expensive.

“The central bank must tread with caution in its next moves,” Ilan Goldfajn, former central bank president who’s now chairman at Credit Suisse, said in a webcast last week. “The lower rates may add pressures over the real, and Brazil runs the risk of losing its currency anchor.”

Deeper Recession

To be sure, mounting economic gloom means there’s no shortage of reasons to keep cutting rates. Analysts surveyed by the central bank expect inflation this year to ease well below the 2.5% floor of the target range, while organizations such as the International Monetary Fund warn the economy will contract by about 5% on crashing demand.

Brazil’s central bank declined to comment for this story.

Going forward, investors will likely remain on edge as investigators probe whether or not Bolsonaro committed crimes including identity fraud and corruption. That backdrop will strain political ties and keep speculation about his possible impeachment alive even as the coronavirus pandemic worsens.

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