Macro Brazil July 21, 2017

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1 Macro Brazil July 21, 2017 Copom Cockpit: The disinflationary scenario prevails The Brazilian Central Bank's Monetary Policy Committee (Copom) will meet again next week. Recent data pictures an environment of low inflation and anchored expectations, with mixed signals in activity data, suggesting a gradual albeit increasingly widespread recovery. Copom's inflation forecasts are expected to drop slightly for 2017 and Although in theory the recent political uncertainty shock could have ambiguous effects on inflation, most recent data suggest that the impact has been largely disinflationary so far. Thus, we expect the Copom to cut the policy rate by 100 bps at next week's meeting, maintaining the easing pace of the previous meeting. In its statement, we expect the Copom to indicate that the extent of the monetary cycle and the easing pace will depend on inflation forecasts and expectations, the evolution of economic activity data and risk factors associated with the scenario - including non-economic factors. We revised our forecast for the Selic rate at the end of the cycle to 7.0%, a level that would be reached in the first quarter of Our scenario contemplates reductions of 75 bps in September 2017, 50 bps in October and December, taking the Selic rate to 7.5% by the end of 2017, and more parsimonious movements at the beginning of next year, with two 25 bps reductions finally taking the Selic rate to 7.0% 1 Recent data Inflation data continued to come below expectations, with a widespread decline among components. In particular, services inflation, an item of special interest to the monetary authorities, maintained the recent pace of decline, reflecting the large slack observed in the labor market. In June, the IPCA index posted a monthly deflation for the first time since June In terms of wholesale prices, indexes again posted a monthly deflation, given the drop in agricultural commodity prices. Economic activity, on the other hand, has been showing ambiguous signs, suggesting a still gradual but increasingly widespread recovery. Industrial production posted a positive variation in May, above expectations. It is worth noting that this is the second consecutive increase in the monthly variation, a sign that the recovery has become more widespread. However, with higher uncertainty, industry confidence declined in June (a movement only partially reversed in the preliminary results for July), which could negatively affect industrial production ahead. In fact, the first coincident indicators indicate a decline in industrial production in June. In the labor market, there was formal job creation in June, below expectations. However, seasonally adjusted, 13,700 formal jobs were lost, a level still consistent with an increase in the unemployment rate. Finally, activity in the services sector and retail sales stood above expectations in April, but came out lower than expected in May. Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.

2 Release Date Indicator Result Consensus 1-Jun-17 1Q17 GDP - QoQ 1.00% 1.00% 2-Jun-17 Industrial Production (Apr/17) - MoM 0.60% 0.10% 9-Jun-17 IPCA (May/17) - MoM 0.31% 0.47% 13-Jun-17 Retail Sales (Apr/17) - MoM 1.00% -0.70% 14-Jun-17 Services sector output (Apr/17) - YoY -5.60% -5.80% 16-Jun-17 IBC-Br (Apr/2017) - MoM 0.28% 0.27% 20-Jun-17 Formal Job Creation (Mai/17) - Thousand Jun-17 IPCA-15 (Jun/17) - MoM 0.16% 0.11% 29-Jun-17 IGP-M (Jun/2017) - MoM -0.67% -0.65% 30-Jun-17 National unemployment rate PNAD Contínua (May/17) 13.30% 13.60% 30-Jun-17 Fiscal: Primary Result (May/17) - R$ billion Jul-17 Industrial Production (May/17) - MoM 0.80% 0.60% 7-Jul-17 IPCA (Jun/2017) - MoM -0.23% -0.19% 12-Jul-17 Retail Sales (May/17) - MoM -0.10% 0.30% 13-Jul-17 Services sector output (May/17) - YoY -1.90% -1.80% 14-Jul-17 IBC-Br (May/2017) - MoM -0.51% 0.20% 17-Jul-17 Formal Job Creation (Jun/17) - Thousand Jul-17 IPCA-15 (Jul/17) - MoM -0.18% -0.10% Source: IBGE, Brazilian Central Bank and Bloomberg Economic Indicators: Result vs. Consensus Data in red suggest more hawkish results for monetary policy (higher inflation or stronger activity than expected) and data in blue suggest more dovish results. On the fiscal side, monthly results still fall short of the year's target, reinforcing the need for approval of adjustment measures and leading the government to announce an increase in the PIS/Cofins tax over fuels. Political uncertainty has remained high since the most recent Copom meeting, delaying the pension reform proceedings to the second half of the year, or even to The proposal is on hold, waiting for strengthened political support before it is voted in two rounds in the Lower House plenary, and then forwarded to the Federal Senate. In a more uncertain environment, meeting fiscal targets becomes even more challenging, delaying the gradual reversal of the Brazilian fiscal imbalance. 2 Inflation forecasts Copom's inflation forecasts, considering Focus survey's interest rates and exchange rates, are likely to be lower than the figures reported at the May meeting, as inflation expectations continued to decline. Since the May meeting, inflation expectations dropped from 3.95% to 3.29% in 2017, and from 4.40% to 4.20% in Expectations for the Selic rate fell from 8.5% to 8.0% (for 2017 and 2018). As for the exchange rate, expectations point to slightly depreciated rates, at 3.30 reais in 2017 (from 3.25 reais previously) and 3.45 reais per dollar in 2018 (from 3.37 reais per dollar at the May meeting). The table below summarizes the estimates based on our model, which attempts to replicate the BCB's small-scale model. We estimate that the inflation forecasts presented to Copom decreased from 4.0% to 3.7% in 2017 and from 4.6% to 4.5% in Page 2

3 IPCA forecasts (%) according to "Central Bank model" in the market scenario* Period May Meeting 2nd Quarter IR July Meeting Exogenous variables evolution Exchange Rate (R$/US$) Exchange rate (R$/US$) Exchange rate (R$/US$) Selic Interest Rate (%) Selic Interest Rate (%) Selic Interest Rate (%) Inflation Expectations (Focus) Inflation Expectations (Focus) Inflation Expectations (Focus) Regulated Prices ** (%) Regulated Prices ** (%) Source: Bloomberg, Central Bank of Brazil, Itaú. * Model developed by Itáu replicating Copom's model. For the May Meeting and 2QIR, we show Copom's forecasts. ** We consider Copom's forecasts for regulated prices. 3 Communication changes and the Copom-o-Meter In the statement of the most recent Copom meeting, released on May 31, the committee signaled that a moderate reduction in the pace of monetary easing should be adequate at its next meeting, to be held on July 25 and 26. With a 100 bps cut in May, the signaling of a moderate pace reduction indicated a 75 bps cut for the July meeting. On the other hand, the statement also stressed that the effect of heightened uncertainty on the continuity of reforms and adjustments in the economy could have negative impacts on economic activity, thus denoting that the July decision would still depend on the evolution of economic data. In the minutes of that same meeting, released on June 6, the mention of the potential negative impact of uncertainty on economic activity was complemented by a consideration of the possible effects of uncertainty on price formation (namely, inflation expectations) and on the estimates of the structural interest rate. Such effects would have the opposite direction to the recessionary and disinflationary impact of the uncertainty shock, which would imply a more austere monetary policy stance. Also in the minutes, the committee stressed that the easing pace depends on the current stage of the monetary policy cycle, thus supporting the statement's message that a moderate reduction in the easing pace at the June meeting would probably be adequate. However, in the Inflation Report (IR) released on June 22, the Committee reduced the impact of the signaling of a moderate reduction in the easing pace by referring to it in the past tense. Additionally, the IR emphasized the data dependence of the next monetary policy decision, thus making it clear that a more adverse economic activity scenario with subdued inflation expectations could lead to the maintenance of the easing pace at 100 bps. In trying to anticipate the Copom's decisions based on BCB's communication, we use the Copom-o-Meter, an index that measures the level of implicit policy contraction or easing in BCB's communication. Applying the methodology, we conclude that the tone of the communication adopted and its evolution are consistent with an interest rate cut between 75 bps and 100 bps, but closer to the latter value. Thus, the Copom-ometer suggests that the scenario of maintenance of the 100 bps easing pace at the meeting next week is the most probable, although there are still elements in the communication that point to a reduction of 75 bps. Page 3

4 Itaú Unibanco Copom-o-Meter Index, Oct/2010 =100 p.p Copom-o-meter (-1) Copom decision (rhs) Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Source: Banco Central do Brasil, Itaú Unibanco 4 Our view The discussion above suggests that the decision of the next Copom meeting on July 25 and 26 will most likely fall between a cut of 75 bps and 100 bps. Although in theory the recent political uncertainty shock could have ambiguous effects on inflation, most recent data suggest that the impact has been predominantly disinflationary so far. In fact, inflation expectations continue to decline, while indicators of economic activity and confidence have deteriorated. This adds to recent communication (in the IR), which showed a decreased emphasis on a possible reduction in the easing pace. An eventual increase in taxes would hardly reverse this scenario for the July meeting, although it may be an additional reason for Copom to opt for a more conservative pace of reduction of the Selic rate at the September meeting, in order to avoid potential second-round effects in an already advanced stage of the monetary easing cycle. In this context, the Copom will probably maintain the easing pace and, given the continuity of a strongly disinflationary context, the easing cycle is likely to be even larger than previously expected. In short, we expect the Copom to cut the policy rate by 100 bps at next week's meeting, maintaining the easing pace of the previous meeting. In the statement, we expect the Committee to indicate that the extent of the monetary cycle and the easing pace will depend on inflation forecasts and expectations, the evolution of economic activity data and risk factors associated with the scenario - including non-economic factors. With recent data showing the prevalence of a disinflationary environment, we revised our forecast for the Selic rate at the end of the cycle to 7.0%, a level that would be reached in the first quarter of Our scenario contemplates reductions of 75 bps in September 2017, 50 bps in October and December, taking the Selic rate to 7.5% by the end of 2017, and more parsimonious movements at the beginning of next year, of two 25 bps reductions, finally taking the Selic rate to 7.0% (compared to the previous scenario of a Selic rate at 8.0% by the end of 2017 and 7.5% in 2018). It should be noted that a terminal Selic rate of 7.5% in 2017 was our scenario before the intensification of political uncertainty. As we noted in a recent research piece (MACRO VISION What is the impact of heightened uncertainty on future monetary policy steps?), the uncertainty regarding the reforms, particularly the pension reform, favored a steepening of the interest rate curve by raising the long-term neutral interest rate (via reduction of domestic savings in the long run), but reducing the short-term neutral rate (due to a decline in confidence), in a context of anchored expectations and FX stability. Without reforms, the consolidation of permanently lower levels of inflation and interest rates becomes more questionable, but this does not prevent the disinflationary scenario and the depressive effect arising from the uncertainty shock from creating the conditions for an extended easing cycle. Page 4

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