This week the BCB’s monetary policy committee, COPOM, decided to cut the Brazilian base interest rate by 50 bps on the fifth meeting of the year to 11.50%. Even though the decision was in line with our projections and the great majority of market analysts, the voting score was somewhat unexpected with 4 votes to 3 in favor of 50 bps. Although many analysts might say this is a very strong indication of a coming 25 bps cut on the September meeting, we believe this is not yet the case. We believe the split became more intense (last meeting’s score was 5 to 2) due to the recent credibility challenges the BCB has been facing. The divergences between the BCB and the finance ministry on the establishment of the 2009 inflation target was probably the reason one more voting member decided to take a more hawkish attitude. Therefore, it is possible that the next decision will be a 25 bps cut but we do not believe this is a done deal. We strongly believe a further appreciation of the currency has the potential to curb inflation and inflation expectations and thus could keep the BCB cutting the Selic by 50 bps. Aside from the divergences between the finance ministry and the CB, higher inflation is also somewhat worrisome. The IPCA inflation went up from 3.18% in May to 3.69% in June as food and beverage prices jumped on the last two months, against a deflation on the same period of 2006. Food and beverages inflation were –1.65% in June 2006 on a y-o-y basis while in June 2007 it was 6.62%, a quite significant change in environment. However, it is clear that the recent increase in the IPCA inflation does not originate from a generalized increase in prices. The trimmed-mean core remains close to historical lows (3.72% in June) while services inflation also remains close to historical lows since the end of 2002. Even though there could be some acceleration in services inflation, we continue to foresee some disinflation coming from pass-through due to the appreciation of the BRL. We recently revised our yea-end forecast of the IPCA inflation from 3.30% to 3.60% but we do not believe this might be a reason for a significant change in the monetary policy path. Looking at inflation expectations, we remain quite positive expectations are very well anchored. In terms of short-term inflation surprises, June-07 was the first month since February when the IPCA inflation came in higher than the short-term expectations (0.28% vs. expected 0.25%). The 12-months accumulated short-term surprises, which is basically the sum of the last twelve months inflation deviation from expectations, is still negative and thus were not enough to significantly change long-term inflation expectations measured by the 12-months-ahead IPCA expectations. Therefore, even though there are clear pressures from isolated items, there are no monetary policy mistakes or excessive loosening. The BCB credibility remains quite under control. The economy is in fact improving as the 1Q07 GDP showed and also as we can see from the preliminary data, 2Q07 should also bring good results. The quality of the economic expansion is considerably good when we look into investments. Despite the low rate of investment (17%) vis-à-vis the rest of the emerging economies, investments has been one of the most important sources of the growing domestic demand at the same time that production and import of capital goods remain very strong. Therefore, in spite of the growing consumption, the economy is definitely adding productive capacity, which might prevent overheating or cost inflation. Aside from those remarks, we believe the divergence between the BCB and the finance ministry in establishing the 2009 inflation target was quite unfortunate. Instead of taking the opportunity to establish a lower target of 4.0% or 3.5%, the finance minister decided to maintain the current 4.5% target, different from what the BCB voted. The decision ended being a dent on the credibility of the government in appointing an independent institution to lead the monetary policy. The BCB credibility remained somewhat unaffected but the ability that the BCB has to really decide what is done on the monetary front was unexpectedly challenged. For this reason we saw a significant shift of the long part of the nominal yield curve and thus implied inflation expectations. But we also see a setback of longer rates and thus no long-term effects over monetary policy decisions. I invite you to participate with you opinion….
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