Forex Investment and Currency Trading

Inflation in Brazil represents a growing challenge for Banco Central do Brasil (BCB), even though IPCA inflation is closer to its target relative to many Emerging economies where inflation is more dramatically exceeding targets. The market implication is for a 25bp hike in rates at the April 16 meeting and a move lower in USD/BRL to 1.65. The targeted IPCA inflation index gained 0.49% mom during February – above expectations for a 0.45% gain. The monthly advance also contributed to pushing yearly inflation to 4.61% yoy from 4.58% in the previous month. Annual inflation has now exceeded the 4.50% central bank target for the last two months and the upcoming IPCA release will likely mark the third monthly reading in excess of the target. BCB’s “March Inflation Report” recently released highlighted deterioration in the prospects for inflation. Accordingly, BCB revised its targeted IPCA inflation forecast up from 4.3% yoy to 4.6% for year-end. However, BCB continues to expect a decline in the rate of inflation into 2009, albeit settling at a higher peak.

Concern exists throughout the government regarding the slight push higher in inflation. However, the Ministry of Finance is issuing policy proclamations that could prove unfriendly for financial markets. For example, the authorities contemplated the imposition of credit controls to cool domestic demand. BCB highlights strong consumer demand with 33.5% yoy credit growth in 2007, as a driving force behind inflation. However, imposition of credit controls would likely lead to a weakening of financial assets and the BRL. Secondarily, reports surfaced that various officials within the Finance Ministry were advocating a move to a targeted exchange rate system, as well as pushing BCB to keep rates on hold. On the heels of the recent IOF tax changes, these statements were of meaningful concern for markets…pushing USD/BRL to a recent high of 1.76. Central Bank President Meirelles was forced recently to issue an extremely strong series of statements at the Inter-American Development Bank annual meetings in defense of the BCB’s independence. Meirelles stated that the government was committed to a floating exchange rate and inflation target. He went further to state that an inflation target and keeping the exchange rate at a specific level were “incompatible” tasks.

The view is that BCB will likely hike the overnight SELIC rate by 25 bps to 11.50% on April 16. A move to lift rates would mark a decisive statement by the central bank to defend its inflation fighting credibility as well as demonstrate a clear independence of monetary policy. Nonetheless, BCB will likely be somewhat restrained in the upcoming and even subsequent meeting or avoid some calls for a hike of 50bps.

BCB restraint will likely follow 1) only a minor deviation from the present IPCA inflation target and 2) the start of a new monetary cycle. Interestingly, BCB typically moves rates by only 25bps at the beginning or near the end of monetary cycles at least since 2003. A move of 25bps is relatively small as hikes or cuts tend to be large and persist over a series of meetings. For example, BCB rate changes averaged a whopping 64bps when the Central Bank acted since 2003.

Higher rates in the Copom meeting slated for April 16 would mark the first advance in rates since May 2005. A shift in stance would likely provide an important signaling effect for markets and in an environment of strong commodity prices help push USD/BRL to 1.65.