Lula’s call on rate cuts slow Brazil’s GDP

Brazilian President Luiz Inacio Lula da Silva has been attacking the independence and autonomy of the Banco Central do Brasil (BCB) amid the persistently high inflation. Lula said the current level of Brazil’s key policy rate at 13.75 percent was too high and the inflation target of 3.25 percent too low, hinting at a mismatch in the monetary policy.

The policy rate is defined by the Monetary Policy Committee (Copom), which is currently led by BCB Governor Roberto Campos Neto, an appointee of Lula’s predecessor Jair Bolsonaro. Inflation targets are set by the National Monetary Council (CMN), which is composed of Neto, Finance Minister Fernando Haddad, and Minister of Planning Simone Tebet.

Lula’s verbal attacks towards Neto and the central bank led to concerns regarding monetary policy autonomy, which aggravated the existing uncertainty regarding the new government’s fiscal rule and triggered nervousness among investors.

The inflation expectation is currently that consumer prices will rise at an even faster rate. Copom signaled in its most recent meeting that it might not be able to cut interest rates in 2023. In a simulation with stable interest rates over the entire relevant horizon, inflation projections stand at 5.7 percent for 2023 and 3.0 percent for 2024.

Like some other countries, Brazil resorted to expansionary fiscal and monetary policies during the COVID-19 pandemic to prop up the economy and provide resources to the most vulnerable households.

Due to the country’s previous periods of high inflation, the BCB was therefore quick to diagnose the inflationary global environment and was one of the first central banks in the world to tighten its monetary policy. The Selic, or Brazil’s federal funds’ rate, soared from 2 percent to 13.75 percent between February 2021 and August 2022. During this period the inflation peaked at 12.13 percent in April 2022 and has since decelerated to 5.6 percent in February 2023, although still well above the full-year target of 3.25 percent.

BCB’s independence under threat

Although there is no room at present for expansionary policy amid inflation pressures, Lula and the Workers’ Party insist on inducing economic growth through public investments and strong government intervention in Brazil’s economy. However, the current macroeconomic scenario is different from Lula’s two previous presidential terms. His party’s strategy clashes directly with the BCB’s objectives: inflation control instead requires economic slowdown, higher unemployment, and lower credit availability through higher borrowing rates.

Lula is though discussing an interesting point as the current cycle of monetary tightening is the most dramatic in more than a decade. The policy rate went from a record low to a six-year high in just 18 months. The real interest rate, which discounts inflation from the key rate, is around 7.5 percent which is among the highest in the world. Meanwhile, other nations grapple with negative real interest rates amid surging inflation. This illustrates the severity of Brazil’s current tightening cycle and suggests that President Lula is right to be worried about its impact on economic activity.

The investors get nervous when Lula and his allies coerce the central bank governor into cutting the interest rate through public statements as well as street protests, alongside a call to raise the full-year inflation target to justify his demand for rate cuts. This combative approach against the BCB raises concerns about political interference in monetary policy decisions, which violates the central bank’s need for independence to correctly manage the monetary sector. In a country with a fragile fiscal framework and a long history of elevated inflation as Brazil, keeping prices under control is paramount.

Brazil is not alone

Investors remember that a Brazilian government earlier tried to interfere in monetary policy.  In 2011, former President Dilma Rousseff took the same approach towards the BCB and, succumbing to political pressure, the monetary policy committee voted to cut interest rates even though market expectations pointed to inflation remaining above target for one more year. After the BCB started the monetary easing cycle in September, the market expectation for inflation two years ahead de-anchored and continued to trend above the central bank target in succeeding years.

The same approach was observed in Turkey. President Recep Tayyip Erdogan had been very hostile towards the high interest rates set by the Turkish central bank and instructed its governor to cut the policy rate, even when market expectations for inflation for the next two years remained well beyond official targets. After several frustrated attempts to interfere in monetary policy, Erdogan sacked the central bank governor in 2019 and later fired two other governors until he finally had a rate cut in September 2021. While interest rates fell, inflation expectations rose dramatically since then. As shown in graph one Turkey’s inflation remains at 50.5 percent as of March 2023, easing from a peak of 85.5 percent in October 2022.

Impact on financial markets

It is unlikely that Lula will succeed in forcing the policy rate down with his rhetoric. The central bank is committed to keeping interest rates at a restrictive level as long as it is needed, and it will not hesitate to resume the tightening cycle if the inflation path does not go as expected. This scenario implies sustained political noise and market volatility.

Before the October 2022 elections, the Focus Market Readout, a survey conducted by the BCB among market analysts, indicated that the rate cut cycle could begin in June 2023 to bring the Selic down to 8 percent by end-2024. As shown in graph two, after the first three months of Lula’s government, market participants expect that the key interest rate can only be reduced by September onwards and that the Selic will be at 10 percent by the end of next year – a much slower pace compared to previous expectations.

Evidence suggests that Lula’s government will rely on higher tax collections to increase public expenditures. If so, inflation expectations and interest rates are expected to remain high, and investors should be underweighted towards Brazil.

This assessment we are ready to change swiftly. As Brazilian interest rates are at historic highs, any news that translates into a fiscally responsible environment could trigger a move into Brazilian assets again.

This original article has been produced in-house for Lundgreen’s Investor Insights by on-the-ground contributors of the region. The insight provided is informed with accurate data from reliable sources and has gone through various processes to ensure that the information upholds the integrity and values of the Lundgreen’s brand.