BC may have to accept slow reinflation process

Inflation expectations are worsening. In addition to the change in the exchange rate, we will have the price shock from the change in the scale and working hours and possible effects of super-El Niño, in addition to the uncertainties surrounding the implementation of the tax reform. This reform, it is worth highlighting, is in my opinion the most important structural reform we have carried out since the Real Plan and will be the great legacy of Lula's third term.

My BTG colleague Tiago Berriel's team considers that the IPCA will run at 5.9% in 2027. Other houses have similar numbers. Brazilian inflation looked like 6%.

On Wednesday (4), the Copom (Monetary Policy Committee) of the Central Bank kept the interest rate stable at 13.75%. Over the next year, the BC will face a very difficult choice: if it looks at the inflation objective, it will have to start a cycle of raising interest rates; If you look at activity, which is expected to have growth close to zero in 2027, you will come across the secondary objective of smoothing the economic cycle and will not start a cycle of increasing interest rates.

The purchasing managers index for the Brazilian services sector, PMI services, showed a sharp drop to 44.5 in October, compared to 49.2 in September. When the index drops below 50, it signals a contraction in activity. It appears that the cyclical reversal has arrived.

President Lula's decision, in November 2022, to reverse the political cycle of public spending generated very high interest rates for a long time. The Selic rate of 13.75% is the same as that in force when Lula resumed the Presidency, in January 2023. Companies and families are very hurt, a fact expressed by the wave of judicial recoveries and defaults. The commitment to family income, despite excellent employment and income indicators, is at historic highs.

The Lula government's objective, for more than meritorious reasons, is to advance the construction of the welfare state at a faster rate than the growth of the economy: for an 11% expansion in the country, primary spending increased by 21%. As the economy is at full capacity and public spending is growing at a faster rate than GDP expansion, the material base of this economy is under pressure and with it interest rates.

It is possible that the economy will not withstand a cycle of monetary tightening. That is, a cycle of rising interest rates generates such an intense wave of judicial recovery of companies that it becomes unfeasible. In this case, the Central Bank will have to passively watch the rise in inflation.

Experts in monetary theory know that there is a point at which public debt is so large and its average maturity is so short that interest rates lose the ability to control the excess of demand over supply. This situation is known as fiscal dominance. It doesn't look like we're anywhere near that point.

But it appears that we are close to a point that we can call "real sector dominance." The destructive impact on the real sector of the economy of a new monetary tightening could be so intense that the Central Bank, even though it is far from fiscal dominance, decides to accept a slow process of reinflation of the economy.

Looks like that's where we're headed.