Depec Highlight Bradesco

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1 Depec Highlight Bradesco July 4, 2018 Central Bank of Brazil communication for the last three monetary policy cycle endings Robson Rodrigues Pereira Igor Velecico An analysis of Central Bank of Brazil communication for the endings of the last three monetary cycles shows that the end of the most recent process, from March of this year, was reported quite differently from 2012 and Upon closing the most recent easing cycle on March 21, the BCB avoided using terms that would give the impression that the Selic would remain stable for an extended period of time. To the contrary, it opted to maintain interest in the short term, for the next meeting of the Monetary Policy Committee (Copom) alone, which could be called mini forward guidance, and whose duration would be on the order of 45 days, which is the time between committee meetings. This strategy apparently reflects the currently high level of uncertainty on the variables driving future monetary policy decisions. This uncertainty rests, for example, on the continuity of the reform agenda for the next government, which would affect the perception of the economy s neutral interest; there is also uncertainty on the resolution of geopolitical and trade conflicts, as well as the overall magnitude of the U.S. dollar strengthening throughout the world, which may affect the BCB s estimates for 2018 and 2019 inflation. Short-term data is also contaminated following the truckers strike at the end of May, which should temporarily produce higher inflation and weaker economic data. These are all arguments that reinforce the choice for the more open communication. We understand that this communication is part of new strategic guidance. According to the BCB itself 1, the main guidelines for this strategy are: 1. The BCB believes that conditioning the future evolution of the monetary policy on factors relevant to inflation adequately transmits the economic rationality guiding its decisions. 2. This communication method is based on data instead of dates. In other words, the messages react to the evolution of the data presented, which helps understand the current actions and forecast future actions by the monetary authority. 3. Decisions are made based on subjective assessments, but always backed by solid evidence on the relevant factors, obtained from data analysis. 4. The communication favors the overall message and avoids using key words to convey its assessments or indicate future actions. Official documents must be analyzed as a whole. We are faced with a different communication standard for the most recent ending of the monetary adjustment cycle than what has prevailed in the previous two cycles. Both in 2012 and in 2015, the password used by the BCB was the term sufficiently prolonged period. Upon ending a long monetary easing cycle on October 10, 2012, which led the Selic to its lowest rate to that point, the monetary authority stated that considering the balance of risks for inflation, recovery of the domestic economy and the complex international environment, the Committee understands that the stability of the monetary conditions for a sufficiently prolonged period of time is the most appropriate strategy to ensure inflation convergence to the target, even if in a non-linear manner. 1 See the communication athttps:// Macroeconomic Research Department 1

2 Base interest remained stable for the period at 7.25% for three consecutive meetings, and was raised again on April 17, The term sufficiently prolonged was used by Copom again in November/2012 and January/2013 communication, but was deleted in March/2013, signaling an imminent increase for the subsequent meeting. In turn, for the upward cycle closing on July 29, 2015, when base interest reached its highest post-global crisis level, the communication indicated that Copom unanimously decided to raise the Selic rate 0.50 p.p. to 14.25% p.a., without bias, after assessing the macroeconomic scenario, inflation perspectives and the current balance of risks. The Committee understands that maintaining the base interest rate at this level for a sufficiently prolonged period of time is necessary for inflation convergence to the target at the end of In this case, the Selic remained stable for nine consecutive meetings, and was only reduced on October 18, The term sufficiently prolonged was only used in the two subsequent notices (September and October 2015); in the November edition, two of the eight members of the committee voted to increase the rate. The possibility to reduce the Selic was only considered again in the August/2016 notice. An interesting question: how did agents interpret the sufficiently prolonged period that lasted 189 days in the first case and 447 days in the second? The following charts answer this question by demonstrating the evolution of the Focus Research forecasts for the base interest rate at the end of 2012, 2013 and 2014 and for the IPCA in the same periods. It is interesting to note that the expectations for the 2013 Selic only converged to 7.25% one month after signaling maintenance of the base rate (Chart 1). Inflation estimates, however, began to climb over time, as shown in Chart 2. Chart 1: Selic forecast (end of the period, %) Chart 2: IPCA (consumer price index) forecast (%) /03/12 10/15/12 10/27/12 11/08/12 11/20/12 12/02/12 12/14/12 12/26/12 01/07/13 01/19/13 01/31/13 02/12/13 02/24/13 03/08/13 03/20/13 04/01/13 04/13/13 04/25/13 05/07/13 05/19/13 05/31/13 10/03/12 10/15/12 10/27/12 11/08/12 11/20/12 12/02/12 12/14/12 12/26/12 01/07/13 01/19/13 01/31/13 02/12/13 02/24/13 03/08/13 03/20/13 04/01/13 04/13/13 04/25/13 05/07/13 05/19/13 05/31/13 Source: Central Bank of Brazil, Bradesco The shaded areas reflect the period of a stable base rate. We observe something similar in the stable interest period in 2015/2016. Chart 3 reveals that the Selic forecast for 2016 converged to 14.25% about two months after the sufficiently prolonged indication, continuing on a high trend from then on, which is compatible with the deterioration shown in Chart 4, not only for the 2015 IPCA, but also for the following two years. Macroeconomic Research Department 2

3 Chart 3: Selic forecast (end of the period, %) Chart 4: IPCA (consumer price index) forecast (%) /09/15 07/03/15 07/27/15 08/20/15 09/13/15 10/07/15 10/31/15 11/24/15 12/18/15 01/11/16 02/04/16 02/28/16 03/23/16 04/16/16 05/10/16 06/03/16 06/27/16 07/21/16 08/14/16 09/07/16 10/01/16 10/25/16 11/18/16 06/09/15 07/03/15 07/27/15 08/20/15 09/13/15 10/07/15 10/31/15 11/24/15 12/18/15 01/11/16 02/04/16 02/28/16 03/23/16 04/16/16 05/10/16 06/03/16 06/27/16 07/21/16 08/14/16 09/07/16 10/01/16 10/25/16 11/18/16 Source: Central Bank of Brazil, Bradesco The shaded areas reflect the period of a stable base rate. As illustrated in Chart 5, the behavior of the interest rate futures market, in turn, is compatible with the perception of worsening fundamentals in the following months, in both cases and despite base interest stability. In the case of 2012, this upward market trend actually anticipated the monetary policy s next move, but was associated with inflation forecasts continuously above the target and with the perception that the BCB s reaction would be milder than expected. On the other hand, we initially see a substantial deterioration in the market rates in 2015, reflecting both a worsening perception on the Brazilian fiscal situation and a deteriorating international environment, with capital flight in the Chinese economy. Later, as the recession intensifies, the market anticipated what would in fact become a downward Selic cycle. The futures market is worsening once again in the current base interest stability cycle, but different from previous episodes. This time, the downturn appears to be more associated with the uncertainty on reform continuity than an excessively expansionary monetary policy. In fact, both the market and the BCB have anchored inflation forecasts for subsequent years on the target or slightly below it, current inflation remains controlled and the economy s idleness tends to cause the strong exchange rate depreciation of recent months to transform into a change in relative prices, with contained side effects. At any rate, events such as the current situation reinforce the importance of solid economic (fiscal) fundamentals to soften global currency movement. Chart 5: daily evolution of interest rates for 180, 360 and 720 days Rate days 4 Rate days 2 Rate days Source: Bloomberg, Bradesco. The shaded areas reflect the periods prior to base rate maintenance. Macroeconomic Research Department 3

4 The importance of the Central Bank of Brazil s communication Literature on monetary policy has been increasingly highlighting the relevance of the communication between central banks and the various segments of society. The monetary authority issues communication to: (i) provide accountability as a democratic practice, since its decisions affect broad segments of the population; (ii) exercise the monetary policy, through available transmission channels; (iii) clarify standards and regulations for the financial community, avoiding excess that leads to losses for society; and (iv) contribute to the financial and economic education of the agents. The central banks only have direct control over the short-term interest rates. However, the economic agents decisions depend on rates with longer maturities, formed in the financial market, as well as other relevant prices for the behavior of the aggregate demand. The interest curve and the inclination between its vertices and the short-term rate are extremely dependent on the agents forecasts, not only with respect to the evolution of the future scenario, both foreign and domestic, but especially with regard to how monetary policy is expected to react to this same scenario. In this sense, the Term Structure of Interest Rates (ETTJ) is directly influenced by BCB communication, as well as premiums that capture terms, risks and specific conditions on supply and demand associated with each vertex on the curve. As time goes by, the communication of some central banks evolved to explicit numbers for the trend expected by authorities for the base interest rate, called forward guidance. The most well-known examples are the Reserve Bank of New Zealand (New Zealand), the Norges Bank (Norway) and Riksbank (Sweden). As a general rule, these trends are contingent on the economic state (state-contingent) or a specific period (timecontingent), but may be communicated in a more open manner (open-ended). Any changes to the flight plan with respect to previous announcements may affect the credibility of the monetary authority, which is why the central banks prefer to make careful and conditional announcements, which allow the public to identify if changes to the flight plan are due to changes in expectations for the scenario s evolution or in the authorities preferences. Conditional commitments to the materialization of a set of hypotheses is needed due to economic nature itself. The world is not linear and is subject to an infinite number of situations and shocks, rendering it unfeasible to consider all possible circumstances that will be faced by the central bank, regardless of the technical team s abilities. As a result, if the scenario changes, the trend expected by the central bank for the interest it has determined also changes. In the post-global crisis era, this communication consistency issue, in which if A occurs, the interest rate should move toward B gains another, more generic aspect. Without the option for additional use of the conventional monetary policy instrument, due to zero lower bound interest (ZLB), central banks like the Federal Reserve use the communication to stimulate the economy, to complement the purchase program for trillions of U.S. dollars in long-term bonds, whose main objective was to shift the interest rate curve down and inject liquidity into the financial system. For example, throughout 2013/2014, the Fed explained that it would maintain the short-term interest rate at its floor while: (i) the unemployment rate, which reached 10% with the crisis, was above 6.5%; (ii) inflation projected for 1 and 2 years ahead remained at most 0.5 p.p. above the target of 2.0%; and (iii) long-term inflation expectations remained well anchored. In 2014/2015, in turn, the Federal Open Market Committee (FOMC) used phrases such as the Committee predicts that, even after employment and inflation reach levels consistent with the [Fed s] mandate, economic conditions may ensure the maintenance of interest rates at levels lower than the long-term rates for some time. Macroeconomic Research Department 4

5 In both episodes, the conditionality of the interest rate trend indicated by the Fed was more generic than in the conventional cases, but quite effective to avoid a depression similar to that of the 1930s. In the first case, they use thresholds, from which interest rate changes would be made. The time period for the second is undefined, but subject to economic recovery. The idea of maintaining the monetary policy on accommodating ground depended on the agents expectation on whether the base rate would remain at ZLB and there would be no early normalization of the rates, which contributed to maintaining the interest rate curve at stimulating levels. The communication complemented the operational action (increase in the Fed balance), thereby strengthening it. Forward guidance may be used at any point in the monetary cycle, but during times of interest rate cycle ending, communication challenges tend to be extended in two directions. The first, in the sense of belief on the part of authorities that the adjustment made was sufficient to attain the desired results. The second is in light of the monetary policy lags, since part of the adjustment will impact the economy only after the interest rate cycle ends. In other words, clear communication from the monetary authority increases the effectiveness of its transmission to the economy. The communication is also a two-way street and, as such, the authorities also benefit from information coming from the private sector, in regular meetings with market analysts and through indications given by financial asset prices. As a result, the more precise and objective the communication, the less chance for potential noise to arise therefrom. Macroeconomic Research Department 5

6 Technical Staff Director of Economic Research and Studies Fernando Honorato Barbosa Economists Andréa Bastos Damico / Constantin Jancsó / Ellen Regina Steter / Estevão Augusto Oller Scripilliti / Fabiana D Atri / Igor Velecico / Leandro Câmara Negrão / Mariana Silva de Freitas / Myriã Tatiany Neves Bast / Priscila Pacheco Trigo / Rafael Martins Murrer / Robson Rodrigues Pereira / Thomas Henrique Schreurs Pires Interns Ana Beatriz Moreira dos Santos / Camila Medeiros Tanomaru / Felipe Yamamoto Ricardo da Silva / Isabel Cristina Elias de Souza Oliveira / Lucas Maia Campos / Renan Bassoli Diniz / Thaís Rodrigues da Silva economiaemdia.com.br DEPEC BRADESCO is not responsible for any acts/decisions taken on the basis of the information available through its publications and projections. All data or opinions contained in the information herein is carefully checked and prepared by fully qualified professionals, but should not be taken, under any circumstances, as a basis, support, guidance or standard for any document, assessment, judgment or decision-making, of a formal or informal nature. Thus, we emphasize that all consequences and responsibility for the use of any data or analysis of this publication are assumed solely by the user, exempting BRADESCO from all actions resulting from the use of this material. We also point out that access to this information implies acceptance of this term of responsibility and usage. The total or partial reproduction of this publication is strictly prohibited, except with authorization from Banco BRADESCO or full citation of the source (naming of the authors, the publication and Banco BRADESCO). Macroeconomic Research Department 6