BCB vs. Lula, where do we stand?
Is truce between the Lula government and the central bank about to end?
The relationship between the Central Bank of Brazil (BCB) and the Lula government has been the cause of much anxiety for markets, and will continue to be. Despite the recently approved operational autonomy for the BCB (often mischaracterized as “independence”), it is no longer possible today to think or predict the trajectory of monetary policy without contextualizing the BCB’s decisions taking into account its relationship with the government.
In recent weeks, from the interview of Roberto Campos Neto on the interview show “Roda Viva”, we had a relative truce in the relationship, and an implicit agreement between the government and BCB for an accepted “sequence of events”, where first the government "delivers" on the fiscal question, for the BCB to then “deliver” loosening monetary policy.
It is worth here to summarize what would be the "Haddad Plan” to address the fiscal question, which is composed of four key components (we leave out tax reform, which in theory is supposed to be revenue neutral).
The first was, via the “Transitional Constitutional Amendment”, a recomposition of spending programs that were (in the view of the current government) unsustainably repressed by the last government.
Second, increases in revenues that had also been cut by the Bolsonaro government for electoral reasons so as to deliver a primary deficit at around to 1% of GDP. The recent reinstatement of fuels taxes is part of this agenda.
Third, with a lower a primary deficit this year, present and pass a new fiscal framework that anchors fiscal expectations for the medium term, with the proposal coming out in the next few days.
Fourth (this part receives less media/market attention, but can be very important), the Planning Ministry will undertake a spending review of existing programs that can generate lower spending while maintaining the same/greater social impact, seeking to increase government productivity. This would be the spending cuts contribution to overall fiscal balance.
This "plan" is not what much of the market would like to see, but taking into account that we are talking about a left-wing government, it is something coherent and, if executed competently, it can potentially achieve its objectives.
But outside ideological differences, what else justifies the current pessimism of the market with the "plan", and with the Lula government overall?
First, measures to increase revenues depend in part on Congress, and it is well known that Congress is averse to tax/revenue increases (increases in spending are another matter).
Second, there is the belief that the proposal for a new fiscal anchor will not have credible spending control mechanisms. Either it will boil down to a set of forecasts, or if there is some automatic control mechanism, there will be several "escape clauses", which means they will not be biding constraints.
Same thing for any spending review: the lobbies that form, inside and outside the government, around any spending program will fight to keep the existing spending/programs as they are.
These concerns are not unfounded, and it is the responsibility of the government, and its theoretically broad congressional base, to show results.
But it is also on these points that we have a mismatch of expectations with the Central Bank. Exactly what is considered as a sufficient "delivery" in the fiscal agenda for BCB to cut interest rates?
The first problem is that any monetary policy loosening cannot only depend on pacifying fiscal uncertainties. This point was lost during the period of criticism of the BCB by Lula, since the government has the view that current inflation is caused by supply shocks and the excessive fiscal easing of the Bolsonaro government during the election. So, if the fiscal issue is addresed, the BCB should immediately cut the level of Selic.
In his interview with Roda Viva, Roberto Campos Neto repeatedly referred to the fact that at the end of last year market expectations showed the possibility of cutting interest rates around the middle of this year. If this today is no longer true, it’s because inflation expectations have increased sharply due to fiscal uncertainties. To “return to what was lost”, we would have to see a sharp fall in inflation expectations, which are in the BCB modeling framework the variable of greatest importance. It is unlikely that we are to see much material improvement in expectations until the government shows concrete delivery in the three points listed above, and that will not happen in the coming months.
So, if BCB’s definition of "delivery" effectively depends on inflation expectations as collected in the Focus survey, there is not much chance of a positive response from BCB at the upcoming Copom meetings. The BCB may - given the fact that its decisions are judgments and not just reflections of its the forecast and market expectations - decide to take another path, but this does not seem to be the modus operandi of the current committee.
It is therefore imperative that there be a frank conversation with the government on the part of the BCB to align expectations on these issues. The BCB has to make clear what are the minimum conditions to potentially start an interest rate cutting cycle. This is something that has to happen directly, and not ex post in its minutes. If this does not happen, the recent truce will end quickly, with negative consequences for all involved.