No room left for rate cuts if inflation target is the goal, Srour says

Despite attempts to clear up some of the confusion in its latest communications, Brazil’s Central Bank has continued to raise questions about whether it is more concerned with economic activity than with inflation. At the same time, uncertainty has been growing—well before the June policy meeting—over the central bank’s so-called reaction function in conducting monetary policy. Oil drop gives little room for more Selic cuts ASA sees ‘financial repression’ ahead, favors real assets “The Central Bank needs to act. If it is truly aiming to bring inflation back to the midpoint of the target, there is no longer any room to cut interest rates. It would be unfortunate to take a step back from the transparency in communication that we have had since 2016,” said Solange Srour, head of Brazil macroeconomics at UBS Global Wealth Management. Srour noted that recent discussions on monetary policy have increasingly blurred the distinction between the Central Bank’s reaction function and its use of forward guidance. She addressed the issue in a report to clients obtained in advance by Valor’s Intraday column. “I disagree with the view that the market wanted forward guidance and did not get it. What the market really wants is to understand the Central Bank’s reaction function—that is, how it is likely to respond under different scenarios. The objective was never to receive explicit guidance on its next moves,” she said. Forward guidance is typically used by central banks to signal their likely policy path. Brazil’s Central Bank itself relied heavily on the tool, particularly in late 2024, when it raised the benchmark Selic rate by 100 basis points and explicitly committed to additional increases of the same magnitude. Srour argues, however, that the current uncertainty stems from the reaction function itself, owing to ambiguities in the Central Bank’s communications following recent meetings of the Monetary Policy Committee (Copom). Since March, the committee has reduced the Selic rate by a quarter point at each meeting while simultaneously acknowledging a deterioration in domestic economic conditions, without explaining how those developments affected its decisions or how they might influence future policy choices. “The market has legitimate questions: Is the Central Bank really targeting the midpoint of the inflation target? Will it accommodate shocks or not? Typically, the combination of the Central Bank’s forecasts and communications allows the market to understand its monetary policy framework. The forecasts and models are not forward guidance—they are framework guidance, helping explain how the Central Bank reacts. But everything has become very confusing. The Central Bank tried to explain that it had not changed the relevant policy horizon and introduced an alternative scenario to justify the Selic cut, but in my view that does not hold up,” she said. The term “framework guidance” was also used last week by European Central Bank President Christine Lagarde during the Sintra Forum in Portugal. Speaking alongside other central bankers, Lagarde said she had regretted becoming constrained by forward guidance on some occasions. “What we do now is explain to market participants how we arrive at our monetary policy stance. That way, anyone interested in understanding our decisions can see the factors we consider and the reasoning behind them,” Lagarde said. Another point highlighted by Srour is the absence of alternative scenarios with explicit assumptions in the June Copom meeting—an exercise the Brazilian Central Bank has presented in the past. While the committee referred to its 2028 inflation projection in both its policy statement and meeting minutes, that figure was only disclosed later in the Monetary Policy Report. Srour also argued that Brazil’s inflation target range already allows inflation, as measured by the IPCA consumer price index, to fall below the 3% midpoint in some circumstances, just as it allows inflation to exceed that level. “There was no need to introduce a different policy horizon to explain the reversal of the shock. That reversal could simply be accommodated within the target range,” she said. “It was not helpful to create the impression that the horizon had been extended. In practice, extending the horizon is equivalent to changing the target. If you keep pushing it further out whenever your assumptions fail to materialize, you are effectively changing the target and accepting inflation outside the range.” She believes the interest rate cut would have been more justifiable if the Central Bank had argued that the output gap—a measure of economic slack—is expected to widen and that the shocks will eventually fade. “But once the Central Bank argues that it does not believe inflation should be pushed below the target midpoint, it inevitably raises questions about whether it is genuinely aiming for that midpoint,” she said. Based on that reasoning, Srour believes the Central Bank is reluctant to allow inflation to fall below the target midpoint because doing so would require a sharper slowdown in economic activity. “We are not talking about a slowdown that could threaten financial stability or anything like that. We are talking about the degree of deceleration needed to bring inflation back to 3%. That was never clarified. The problem was not a lack of space in the statement. I believe the Central Bank is placing too much emphasis on supply shocks and too little on Brazil’s domestic challenges, particularly the significant demand shock stemming from fiscal policy.” According to Srour, the current output gap “does not leave room for disinflation in services,” suggesting that monetary policy may not be as restrictive as the Central Bank believes. “Inflation forecasts are constantly being revised, and the Central Bank has been missing its projections for a long time. Of course, the pandemic created extraordinary shocks, but actual IPCA inflation has generally come in above the Central Bank’s forecasts, even after those projections have been revised,” she said.