With the red-hot Brazilian economy set to grow at 6% this year and its central bank already behind the curve on inflation that is expected to climb above 5%, RBC Capital Markets is warning that Brazil is overheating.
This will likely lead to growing imbalances, asset bubbles and inflation with “deep momentum that could be difficult and risky to correct,” Nick Chamie’s emerging markets research team said in a report.
RBC forecasts inflation in Brazil will rise to 5.4% and 5.6% in 2010 and 2011, respectively. This red-hot performance will be driven by the government’s efforts to expand public-sector bank credit growth, a dramatic expansion government-led investment initiatives, activities related to the 2014 World Cut and 2016 Olympics, more public-sector social progams, and the “Bolsa Familia” family allowance.
RBC’s forecasts suggest that Brazil’s output gap will close by the third quarter of 2010. So within six months, the lead of actual GDP is expected to widen over potential GDP thereafter. Other measures of spare capacity, such as unemployment and industrial capacity utilization, also warn of disappearing slack.
The threat of overheating means the Banco Central do Brasil (BCB) needs to tighten aggressively, RBC said. However, anchoring inflation expectations will be an enormous challenge given how high inflation has risen and the speed at which it has done so.
“Given we are 6-9 months away from the output gap closing (according to our estimates) and monetary policy tends to work with a 12 to 18 month time lag, it is fair to say the BCB is already behind the curve, as reflected in the rapid rise in inflation expectations and the sizeable steepening of the yield curve observed recently,” the analysts said.
The degree of uncertainty has risen in recent weeks following the departure of two key members of the central bank’s COPOM rate-setting panel. Both monetary policy director Mario Toros and economic policy director Mario Mesquita were considered very strong technically and generally hawkish, which served to bolster the BCB’s credibility.
“However, their departure and subsequent replacement has left policy deliberations somewhat uncertain with anecdotal evidence, in out view, pointing to an increase in the dovish voices on the COPOM,” RBC said.
This apparent preference for lower interest rates may serve to limit the chance of a 75 basis point increase to beging the rate hiking cycle.
“This would raise the odds of a larger and lengthier rate hiking cycle needed to contain inflationary pressures,” the analysts said. They currently forecast a 400 points of rate hikes in the next 12 months.