Political Crisis and Loss of Degrees of Freedom in Conducting Economic Policy

BRAZIL ECONOMICS - Report 27 Aug 2015 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

Against the backdrop of stagflation and a politically weak government, the Central Bank is facing two challenges. The first is the need to keep interest rates high for longer, even in face of the deepening recession, which raises the political pressures for easing. The second is the task of absorbing the additional pressures on the exchange rate resulting from the reduction of the primary fiscal surplus targets, which is largely due to the government’s political weakness.

The recession is getting worse. In the second quarter this year, the negative GDP gap reached 3%, the second worst result in history. Net downsizing in the formal job market has been holding at around 150 thousand per month, causing the accrued figure for 2015 to rapidly approach the 1 million mark, with the unemployment rate climbing to 7.5%. Despite the recession, the decline of inflation will be slow, with the stagflation scenario preventing earlier and more intense cutting of interest rates.

The administration’s political weakness has led to fiscal relaxation, largely abandoning the plans announced at the start of the year. The worse sustainability of the debt has increased the risk premiums, with Brazil’s CDS quotations reflecting a very high probability of an impending loss of investment grade. This in turn has caused the real to depreciate more than other commodity currencies, aggravating the inflation perspectives even more. With the real under pressure, the likelihood is low that the Central Bank will reduce its interventions in the foreign exchange swap market, and the sale of reserves would worsen the risk more, raising the CDS quotations more and putting stronger pressures on the real instead of alleviating them. The best instrument would be to hike the interest rate further, but this is unlikely in the current stagflationary environment.

The political crisis has been growing worse, with indications that Michel Temer will cease being responsible for political coordination with Congress. If this happens, this function will be assumed by a member of the PT, which has little sympathy for fiscal austerity. In a situation like this, the probability is growing of a return, albeit partial, to the policy stance of Mantega, which Planning Minister Nelson Barbosa favors. The likelihood has also grown that the Central Bank will lose part of its recently achieved independence in conducting monetary policy.

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