Brazil - Economic Briefing June 2004

Economic Activity Picks up but Uncertainty Over Strength of Recovery (continued)

Currency depreciates strongly amid asset sell-off attributed to US Federal Reserve hike jitters
In May, the exchange rate depreciated 5.7% in nominal terms versus the US$, which was the strongest monthly weakening observed since September 2002, when concerns about the presidential election induced a massive deterioration in the currency.  The May exchange rate deterioration followed 1.5% depreciation in April and was associated principally with rising concerns about a possible interest rate hike by the US Federal Reserve, which prompted a strong sell-off in emerging market assets by international investors.  In fact, the Bovespa stock index dropped by 0.3% in May following the 11.5% decline in April.  Furthermore, the spread of the benchmark J.P. Morgan EMBI+ sovereign bond to its comparable US Treasury bond widened 38 basis points to 701 basis points in May.  The depreciation resulting from the asset sell-off brought the currency to 3.13 reais to the US$ at the end of May – 7.7% weaker than at the end of last year.  Despite the ever weaker currency, Consensus Forecast participants have not adjusted their year-end exchange rate estimate significantly, as the currency is seen reaching 3.09 reais to the US$ - 0.9% weaker from last month.  Next year, the currency will depreciate by 5.2% nominally, with the exchange rate closing at 3.26 reais to the US$ by year-end.

Inflation rising amid accelerated economic activity and currency jitters raises inflationary expectations
In May, the consumer price index (IBGE-IPCA 15), which covers monthly price increases up to the 15th of every month, increased 0.54%.  The May figure was up from the 0.21% increase observed in the prior month.  Declining food prices associated with the beginning of the harvest period were offset by more pronounced increases in electric energy and clothing prices.  Electricity tariff adjustments in six of the eleven major geographic areas surveyed by IBGE accounted for the energy price hike, while clothing prices rose amid the introduction of the new autumn/winter collection.  The May price increase remained below the 0.85% spike observed in May last year and, as a result, the annual inflation rate declined from 5.3% in April to 5.0% in May.  Annual inflation, therefore, is now below the Central Bank’s inflation target of 5.5% for this year.  Nevertheless, Consensus Forecast participants anticipate that heightened economic activity and the possibility of more accelerated currency depreciation will exert more upward pressure on prices towards the end of this year, as monetary authorities are expected to overshoot the annual inflation target for the fourth consecutive year.  Thus, inflation is seen reaching 6.5% this year, which is up 0.3 percentage points from last month’s forecast but remains within the +/- 2.5% tolerance margin set by the Central Bank for 2004.  Next year’s Consensus Forecast estimate has also been revised upward – by 0.4 percentage points – from last month to 5.6%, which remains on the upper end of the +/- 2.5% range around the central target of 4.5% set for 2005.

Central Bank maintains monetary policy unchanged
In its meeting on 19 May, the Central Bank monetary policy committee (COPOM) decided to keep the benchmark SELIC rate unchanged at 16.0%.  The May decision followed two consecutive monthly 25 rate cuts that reduced the SELIC interest rate to a three-year low.  The increased volatility in financial markets and prospects for acceleration in economic activity prompted monetary officials to postpone further interest rate cuts for the time being.  However, Consensus Forecast participants appear to expect that the current Central Bank caution is likely to subside throughout the year, as the benchmark interest rate is anticipated to drop to 14.6% by year-end, which is up moderately from the 14.2% expected last month.  Furthermore, the SELIC interest rate is expected to decline further next year to 13.0%.