Morgan Stanley on Brazilian Inflation

Morgan Stanley economists Gray Newman and Daniel Volberg note that Brazilian inflation has been at or below the equivalent US levels in four of the past five months, and expect year end inflation to be in the 3% ballpark. Excerpts from their analysis below:

The most recent surveys of expectations conducted by the central bank show a growing consensus that inflation is likely to come in around 3% in December. This represents a marked decline from forecasts that at the beginning of last month were above 3.6%.

Whether inflation ends the year at 3.1% as we now expect or 3.0% as now expected by the market, the achievement is remarkable because it represents a dramatic departure from Brazil’s legacy as a producer of hyperinflation just a little more than ten years ago. And the achievement is potentially very profitable: after all, Brazil’s yield curve is pricing in only modest rate cuts in the next two to three years. That seems odd when the starting point today is an overnight reference rate, the Selic, standing at 14.25%.

The rub is whether this year’s inflation performance is a one-off consequence of an unusually favourable environment or a sign of what is likely to come. We are still working through the issue, but we suspect that Brazil’s downward drift in inflation represents the beginning of what should be an era of low inflation. [...]

Bottom line: In the past two years, inflation in Brazil has plummeted even as real rates have remained largely unchanged. To some, that may seem like a failure on the part of policymakers. We would argue to the contrary: it is setting Brazil up for a period of extended low inflation which in turn should allow real rates to drop farther than most Brazil watchers can imagine today. Of course, that will require more than just a credible central bank. Brazil’s next administration needs to tackle the urgent requirement to boost both human capital and the country’s infrastructure to prevent higher growth from threatening to end up in an inflation spiral. That in turn will require a new round of fiscal resolve. Stay tuned.

Note: iShares Brazil Index (EWZ) tracks the Brazilian market. It's largest holding--Petroleo Brasileiro--represents 22.74% of the fund.

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