RIO DE JANEIRO, BRAZIL – With a new fiscal stimulus package about to be approved by the U.S., the risk of premature withdrawal of monetary stimulus in the United States is growing among financial market operators and analysts, which may also lead Brazil’s Central Bank to standardize its interest rate policy sooner than expected.
The argument gained greater visibility after former U.S. Treasury Secretary Larry Summers and former chief economist of the International Monetary Fund (IMF) Olivier Blanchard said that President Biden’s fiscal package is too broad and could lend a stronger boost to inflation.
The risk has already been affecting Brazil since the start of the year, through rising interest rates on long-term U.S. Treasury bonds and the inflation rate incorporated in the prices of these bonds. However, more recently, the markets have begun to price this potential more heavily.
In an interview with Valor, former Central Bank director Mario Mesquita, now chief economist of Itaú Unibanco, said that he recently became more alert to the risks of a rise in interest rates in the United States before 2023 – and of Brazil having to step forward toward a standardized basic interest rate earlier than expected. For now, the Central Bank has signaled a withdrawal of the extraordinary monetary stimulus injected during the pandemic. According to market expectations, this means a monetary squeeze between March and May that will raise the interest rate from the current 2% a year to 3.5% in late 2021.
But there is still no market consensus as to when the interest rate could be pushed to its neutral point, which neither stimulates nor depresses economic activity. The market estimates a neutral 3% per year rate, which is equivalent to nominal interest rates close to 6% per year, after factoring in inflation of around 3%.
Central Bank President Roberto Campos Neto has indirectly referred to the risks of stronger interest rate hikes by the Federal Reserve Bank (Fed) in recent weeks. He said that when economies enter a crisis, there is coordination between monetary and fiscal policies, but the solution is often more confusing.
“The market is pricing that this withdrawal will not be as organized as the entry,” said Campos Neto in a recent online event. “This is a topic that may have significant implications, depending on how it unfolds.”
Summers said last week that the US$1.9 trillion fiscal package proposed by Biden to Congress is excessive and could trigger “inflationary pressures never before in a generation, with consequences to the value of the dollar and financial stability.”
Blanchard said he agrees with Summers, although he stressed that the priority must be to protect the economy from the impact of Covid-19. “The US$1.9 trillion program could overheat the economy so severely that it could be counterproductive.”
U.S. Treasury Secretary Janet Yellen reacted to Summers and Blanchard’s concerns in an interview last weekend. She acknowledged the possibility of the U.S. economy reaching full employment next year and mentioned the risk of inflation escalating, but said this outcome is one against which there are tools in place to counter.
“Inflation is a risk that Yellen is willing to take,” said a manager of international funds from Brazil. “She’s not worried about that,” said another source.
Economists are doing the math on when the U.S. economy’s idle capacity could be filled, depending on the magnitude of the U.S. fiscal package. “I think the package should be reduced in negotiations,” said an economist who served on the board of the Brazilian Central Bank. Another says there are controversies over the impact on the economy: Summers and Blanchard are more concerned, but some say that the design of the package tends to lead to less intense stimulus.
Here in Brazil, managers are trying to measure the impacts of the U.S. package. Panamby Capital, with former Central Bank executive Reinaldo Le Grazie among its partners, estimates that a US$1.9 trillion package could fill the U.S. idle capacity by the first quarter of 2022 while a US$1.1 trillion package could defer this to the end of next year.
Full employment is a factor that could lead the Fed to intervene in monetary policy, although the U.S. Central Bank has adopted a no-action approach by placing emphasis on the labor market alone, after a break in the historical relationship between the unemployment rate and inflation. But experts consider that, before a potential withdrawal of monetary stimulus in the United States, the impact in Brazil is starting to be felt, through interest rates negotiated in the market.
The course of normalization of U.S. monetary policy is particularly worrying for Brazil, says an expert, because the level of government indebtedness is higher than in the past. A good part of the market’s patience with slow fiscal adjustment stems from the fact that today, real interest paid on debt is historically low.
Still, the chance of a stronger withdrawal of stimulus in the United States in 2022 is still perceived as less likely, given that there are forces that should help keep inflation low for at least the next 12 months, according to economic analysts.
A tightening of monetary conditions by the Fed in 2022 is regarded as a poor scenario, which would likely make life more difficult for the Brazilian Central Bank. A similar scenario was last seen in 2018, when economies like Brazil, Argentina and South Africa came under heavy pressure.
Source: Valor Econômico