Deflating the economy will not be easy – 08/09/2021 – Solange Srour

According to market projections from the Focus survey, inflation should be 7.6% this year and 4% next year. It’s a hell of a disinflation by our historical standard.

Since the beginning of the inflation targeting regime, in 1999, Brazil has observed only once —between 2015 and 2016— a drop in the IPCA greater than the value implicit in current projections. In that period, inflation dropped from 10.7% to 6.3%, in the wake of a prolonged recession, a substantial rise in real interest rates and a vast appreciation of the exchange rate in response to the return of the macroeconomic tripod.

Today, the Focus hypotheses for the behavior of the Selic, the exchange rate and the GDP are far from what happened in that period. That is, the market believes that inflation is temporary, that its persistence is low and/or that monetary policy is much more effective today than it was in the past.

However, there is a not negligible risk that the inflationary scenario will be much more serious, difficult to control and bring very negative consequences for the income of Brazilians in the coming months. For 14 months, the market has been underestimating inflation. Among the last 11 errors, 8 were above 0.4 percentage point in the month. It is true that the pandemic makes the art of projecting inflation more complex; but, in the Brazilian case, there is a peculiarity that seems to bias inflation projections.

When Covid-19 reached our country, the accumulated inflation was at 3.3% (last 12 months until March 2020), while expectations for the end of the year were at 3.3%, below the target of 4, 0%. At that moment, the idea gained momentum that Brazil had finally broken inflationary inertia, that is, past inflation would have little effect on current inflation. After all, services inflation (always the most inertial group) had finally left the historical level of 7.2% and reached 3.1%.

This concept was corroborated by the BC, which dropped the Selic rate from 4.25% per year to 2% per year between March and August, supported by the market, whose expectations pointed to inflation of 1.6% and 3.0% in 2020 and 2021, respectively.

Unfortunately, more than a year of extremely high inflationary surprises should be enough to call into question the low inertia thesis. It is incredible that this is not happening with the consensus expecting a significant slowdown in inflation in 2022, even more when the discussion of precatories and the obsession with increasing spending in the election year raise doubts about the sustainability of our debt. Historically, moments of fiscal weakness increase the persistence of inflation.

A study I did with Lucas Vilela for Credit Suisse shows that, historically, market expectations for the year ahead are slow to react to inflationary surprises and I calculate that the latter reached 5% in the last 12 months (the highest value since 2004, the year in which the historical series for expectations began).​

For a country whose target is 3.25% in 2022 with a tolerance of 1.5 percentage points, this figure is quite significant. Away from reality, expectations for the next 12 and 24 months remain contained, as can be seen in the chart.

Evidence indicates that the amount of inflation transferred from one period to another is cyclical: when inflation accelerates, persistence increases; when inflation slows down, inertia recedes. Another study carried out by us describes this phenomenon and compares Brazil with other emerging countries. We have the second highest coefficient of inertia, second only to India.

The greatest disinflation after the Real Plan resulted from restrictive real interest (estimated at 7.4% in 2016, 4.3% in 2017 and 3.2% in 2018), from the maintenance of a high idleness of the economy (average unemployment of 11 .3%, 12.8% and 12.3% in 2016, 2017 and 2018, respectively) and the resumption of fiscal credibility (at the end of 2016 the spending ceiling was approved). In fact, high real interest rates were present in the disinflation of 2001/2002 and 2004/2005. There is no magic to contain inflation.

For many, the severity of the inflationary process is not glaring, but the average income from work today is already 2.7% lower than nine years ago. Given that market expectations are key elements in the BC’s decision-making process, the belief that inflation will be controlled without the proper costs being incurred and without the fiscal anchor being strengthened will further impoverish Brazilians in 2022.

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