The Monetary Policy Committee (Copom) cut the Selic rate by 100 basis points (bps), from 11.25% p.a. to 10.25% p.a., at its May 31 meeting. The decision was in line with our forecast and that of the vast majority of market participants (43 out of 47 institutions, according to Bloomberg). The communiqué released after the meeting signaled moderate reduction in the pace of the current easing cycle at July’s meeting. The committee’s view is that greater uncertainty regarding the speed of the approval of reforms has deteriorated the balance of risks for inflation. The committee ascribes a higher probability to scenarios in which reforms are postponed and is uncertain of how inflation would evolve in those cases. The document also emphasized that the reduction in pace is still conditional on the dynamics of economic activity, inflation expectations, and the committee’s own understanding of the extent of the current easing cycle. We share the view that the latest political developments have increased uncertainty regarding the approval of reforms.

At least for the next few months, members of Congress will probably not be inclined to approve any significant bills, especially those that require close coordination, such as social security reform. The most likely scenario is that, if approved, the social security reform will be further diluted, therefore with a milder impact on fiscal accounts. As we have already argued in several of our publications, a strong social security reform is required in order to stabilize primary expenditures and, consequently, to comply with the cap on primary expenditures. The more uncertain scenario regarding the approval of reforms in Congress and the recognition by Copom members that the probability of negative scenarios has increased lead us to revise our base-case scenario for the path of the Selic rate in the coming months. We now expect a smaller rate cut in the Selic rate at the Copom’s next two meetings on July 26 and September 6, from 100bps to 75bps. If our forecast materializes, the Selic rate will decline from the current 10.25% p.a. to 8.75% p.a. in September.

The Copom unanimously decided to reduce the Selic rate by one percentage point, to 10.25 percent per year, without bias. The following observations provide an update of the Copom’s baseline scenario: The set of indicators of economic activity released since the last Copom meeting remains consistent with stabilization of the Brazilian economy in the short run and a gradual recovery during the course of the year. If sustained over a long period, high levels of uncertainty regarding the evolution of reforms and adjustments in the economy can have detrimental effects on economic activity; Stronger global economic activity has so far mitigated the effects on the Brazilian economy of possible changes of economic policy in central economies; Inflation developments remain favorable.

Disinflation is widespread and includes IPCA components that are most sensitive to the business cycle and monetary policy. It is necessary to monitor possible impacts of higher uncertainty on the prospective path of inflation; Inflation expectations for 2017 collected by the Focus survey fell to around 4.0%. Expectations for 2018 are around 4.4%, and expectations for 2019 and longer horizons are around 4.25%; and The Copom’s inflation projections for 2017 and 2018 in the scenario with interest rate and exchange rate paths extracted from the Focus survey are around 4.0% and 4.6%, respectively. This scenario assumes a path for the policy interest rate that ends 2017 at 8.5% and remains at that level until the end of 2018. The Committee emphasizes that its conditional inflation forecasts currently involve a higher level of uncertainty. The Committee views the heightened uncertainty regarding the speed of the process of reforms and adjustments in the Brazilian economy as the main risk factor. This arises from both a higher probability of scenarios that may hinder this process, and the difficulty in assessing the effects of these scenarios on the determinants of inflation. Taking into account the baseline scenario, the balance of risks, and the wide array of available information, the Copom unanimously decided to reduce the Selic rate by one percentage point, to 10.25 percent per year, without bias.

The Committee judges that convergence of inflation to the 4.5% target over the relevant horizon for the conduct of monetary policy, which includes 2017 and, to a greater extent, 2018, is compatible with the monetary easing process. The Copom emphasizes that the extension of the monetary easing cycle will depend, among other factors, on estimates of the structural interest rate of the Brazilian economy. The Committee judges that the recent increase in the uncertainty regarding the evolution of reforms and adjustments in the economy hampers a more timely reduction of estimates of the structural interest rate, and makes them more uncertain. The Committee will continue to reassess these estimates over time. In light of the basic scenario and current balance of risks, the Copom judges that a moderate reduction of the pace of monetary easing relative to the pace adopted today is likely to be appropriate at its next meeting. Naturally, the pace of monetary easing will continue to depend on the evolution of economic activity, the balance of risks, possible reassessments of the extension of the cycle, and on inflation forecasts and expectations.