September 5, 2018 / 4:31 PM / a year ago

Brazil FX crisis boosting passthrough to inflation -central bank study

BRASILIA, Sept 5 (Reuters) - Currency weakness tends to push up inflation more during crises such as the one currently ravaging through Brazilian financial markets, a central bank study showed, suggesting a deeper-than-expected impact from the Brazilian real’s recent slump.

The study, which does not portray the bank’s official position, estimated that a 1 percent rise in the dollar against the real would add 0.1035 percentage points to inflation in the long term in times of crisis. Passthrough under a so-called normal regime is close to zero: only 0.00057 percentage point given a 1 percent exchange rate shock.

At Reuters’ request, the authors of the 2018 working paper reran the model through the first half of this year. The results indicated Brazil entered a new crisis in the first two quarters of 2018, magnifying currency passthrough to levels last seen in 2000-2003 and 2015-16.

Crises, as defined by the study, are characterized by high economical uncertainty and instability.

“There is a big chance of reverting to a high passthrough period due to the force of the external shock”, Fabrizio Marodin, one of the authors of the study, said. That “will only end once the results of the election are known, if it ends”, added Marodin, a PhD candidate at the University of California, Irvine.

Uncertainty around Brazil’s economic and fiscal outlook has run high amid a lack of clarity about the outcome of October’s presidential race.

The dollar firmed around 25 percent against the real this year, nearing an all-time low, weighed down both by local and global factors. Trade tensions abroad have sparked widespread risk aversion, while investors fear that the next president may not cut spending to curb growth of public debt.

Under the paper’s assumptions, the passthrough from that move could reach 2.5 percentage points in the long run. That would be welcome news for the central bank, with a sluggish economic recovery keeping inflation below its target for over a year.

The paper’s most important find, Marodin said, is that the crisis cycle that began in 2015 lasted until the third quarter of 2016 — suggesting a revamp of the bank’s monetary policy board after Ilan Goldfajn took over as governor that year restored confidence in its inflation fighting credentials.

“A more credible central bank, in terms of its willingness to react to inflation, will be able to coordinate agents’ expectations towards lower inflation given the same exchange rate shock”, said Marodin.

Still, the central bank “is no Superman” and is unable to “perform miracles.”

Marodin also echoed recent central bank communication in saying the bank should only react to currency moves insofar as they drive other prices or inflation expectations. That does not seem to be the case at this time, with price forecasts close to the official targets, he said.

According to a weekly central bank survey, economists expect inflation to reach 4.16 percent by year-end, below the government’s 4.50 percent target for 2018 but only a tad less than the 4.25 percent 2019 target. (Reporting by Marcela Ayres; Editing by David Gregorio)

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