Under Lula, Doves Are Rapidly Gaining Power in Brazil’s Central Bank

(Bloomberg) -- Seventeen months into office, President Luiz Inacio Lula da Silva has put his stamp on the Brazilian central bank he has battled throughout his term. Four of the bank’s nine board members are now Lula appointees. And as they’ve grown in number and influence, they’ve begun to slowly shift the mindset inside an institution that has lately been aggressive, and almost obsessed, with its fight against inflation.

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In private settings, some of the new appointees have appeared to focus primarily on the need to support economic growth as inflation eases, even while estimates for future price increases remain nearly 1 percentage point above the country’s 3% target.

In doing so, they have signaled that the bank — or at least a rising faction within it — would prefer to stay “behind the curve,” forging on with rate cuts and delaying eventual hikes even when inflation picks up.

That has clouded the future of Brazilian monetary policy at an already noisy time. Fiscal uncertainty at home and the Federal Reserve’s reluctance to cut its key rate have left economists debating whether policymakers will slow the pace of their current easing cycle — which has dropped the benchmark Selic from a six-year high to 10.75% — when they meet this week. The notion of a “behind the curve” board, meanwhile, has left traders struggling to price in longer-term rate moves: Analysts on Monday inched year-end rate estimates upward to 9.63%.

Question Marks

For much of last year, traders focused on how Lula’s appointment of Gabriel Galipolo — a former Finance Ministry official widely regarded as bank chief Roberto Campos Neto’s likely replacement — would reshape the monetary authority. But Paulo Picchetti, whom the leftist leader tapped as the bank’s director of international affairs, has emerged as the biggest question mark since joining the board in January.

Picchetti, a well-known academic with a background in econometrics who is also among Campos Neto’s potential successors, has given only a handful of public speeches, and said in his first interview with local media that it could be worth slowing the pace of cuts if it leads to lower borrowing costs at the end of the current easing cycle.

Read More: Brazil Analysts Move Toward Higher Year-End Key Rate Forecast

But at a closed-door gathering in Washington last month, he surprised investors by expressing more concern with growth than inflation, according to multiple people who were in attendance. Picchetti argued that the bank faces trade-offs between its efforts to bring down above-target inflation estimates and the risks of hurting the economy, according to six people who requested anonymity to discuss the private talk.

The board, he said, needs to figure out why inflation bets have worsened recently after sticking half-a-point above target for nearly a year. If fiscal issues are the cause, he argued, there isn’t much monetary policy can do.

A spokesperson for the central bank declined to comment.

“The changes to the board have put people in place who don’t have an academic background of ‘strict monetarism’,” said Sergio Werlang, a Rio de Janeiro-based economist who was the architect of the country’s inflation-targeting system in the 1990s. “So the new team will naturally be more dovish.”

That doesn’t mean the bank will recklessly cut rates, Werlang said in a written response to questions. Instead, it is likely to adopt more subtle changes like allowing inflation to run slightly above target to ensure economic expansion.

“I think this is already happening, and will continue,” he said.

But in a country with deep scars from hyperinflation, that approach causes no shortage of angst. Investors have in recent weeks ratcheted up wagers that inflation will remain stubbornly above the bank’s goal through 2027, suggesting that they are increasingly skeptical of policymakers’ claims that they are focused on taming price increases.

Read More: Brazil’s Central Bank Warns Investors of Growing Uncertainties

A loss of faith in the bank’s commitment can cause inflation to quickly accelerate, an argument traditionalists inside the institution seem to use to push back against their more lenient colleagues. Diogo Guillen, the director of economic policy, has raised alarms about “unanchored” inflation estimates and the amount of time they have remained above goal.

His concerns ran so deep during a private gathering in Washington last month that he appeared “obsessed” with the matter, according to multiple people in attendance.

Leadership Transition

Campos Neto, the author of one of the world’s most forceful easing responses to the pandemic, followed by an equally aggressive tightening campaign as the economy reopened, reiterated his own concerns with rising inflation estimates and global uncertainty. The board, meanwhile, has said “firm action” is necessary to bolster the credibility of both monetary and fiscal policy in its official statements.

“Inflation expectations are very relevant for us, and — make no mistake about it — it’s very important to keep them anchored,” Campos Neto said at an April event in Washington. “We know we have a difficult job ahead of us, and we’ll do what’s necessary to anchor expectations. That’s very important to repeat, and repeat again.”

But Campos Neto, who continues to irritate many within Lula’s Workers’ Party, will leave the bank when his term ends in December.

Galipolo, one of Lula’s first appointments, has echoed the board’s calls for “serenity” and “caution” in volatile moments. But in his most recent speech, he said that the being “a little behind the curve” would give the bank time to understand how recent market prices impact inflation goals — a stance traders interpreted as in line with the leftist Lula’s overall view that economic growth should take precedent.

Annual inflation cooled to 3.77% in mid-April, well within the bank’s tolerance range. Most analysts bet they will stick around that level through the end of the year.

“The movement in long term inflation estimates is linked to doubts on who will be the president,” said Marcelo Kfoury, an economics professor and former employee of the central bank. “At some point there’s a trade off, and the question of whether you have the courage to keep cutting arises.”

Read More: Lula Puts an Ally on Track to Lead the Central Bank He’s Fought

Painful memories of lax monetary policy approaches still haunt many in Brazil: During Dilma Rousseff’s presidency a decade ago, the bank failed to react strongly to sharp price increases as the government ramped up public spending, and distrust in its leaders fueled speculation about its actual inflation goals, which in turn lifted future expectations. Sharp interest rate hikes and a recession eventually followed.

Few analysts, however, are betting on a return to those years. The central bank still has the ability to regain control of worsening inflation bets as current prints improve, even if slowly. And while Lula has criticized its approach, he is also a politician aware of the severe impact inflation can have on Brazil’s poorest, said Carla Argenta, chief economist at CM Capital Markets.

“There’s more ambiguity at the moment, and as a whole the bank has been failing in its communication,” she said. “The way to correct market moves is through credibility.”

--With assistance from Martha Beck.

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