Goldman Sachs: Brazilian Inflation Expected To Remain Above Target Until 2017

The Brazilian Central Bank recently released its Quarterly Inflation Report (QIR), a comprehensive analysis of global and domestic economic trends. The paper indicates that inflation is likely to remain rooted at –- or even above -- the 5 percent level until the end of 2016, even assuming a constant BRL/USD at a very favorable 3.15.

In a report issued Thursday, analysts at Goldman Sachs provide some commentary on the QIR.

Given this backdrop, the firm believes that "the MPC will be prompted to extend the tightening cycle, but a number of what we [the analysts] assess as dovish remarks in the QIR suggest that the current tightening cycle may not last long."

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However, in Goldman Sachs' assessment, "ultimately the residual length of the current tightening cycle will be determined by the BRL, for if it does not stabilize and continues to weaken the central bank would be forced to "chase it" and hike by more than is current assumed."

The central bank basically looks through (even downplays) the steep acceleration of inflation in 2015, anticipating a substantial improvement for 2016.

The QIR explains the optimism is based on the expectation that several factors contribute to limiting the pass-through from BRL depreciation to inflation, and on the idea that the impact of this depreciation on relative prices will be circumscribed to the short term (basically, 2015).

In addition to remaining above the target of 4.5 percent over the next couple of years, inflation is expected to surpass 6.5 percent by the end of 2015.

Goldman Sachs believes the central bank projections were based on highly optimistic assumptions regarding the path of the exchange rate.

"Hence, the medium term inflation dynamics may ultimately prove more challenging than the path unveiled in the QIR," the firm explains.

Overall, they forecast that the central bank will be forced to continue to hike rate.

"The terminal rate of the hiking cycle," the analysts add, "will likely be determined by...the behavior of the BRL, the intensity and second round effects from the ongoing regulated tariffs shock, inflation expectations, the performance of the economy," and the speed at which fiscal policy is implimented.

Both the iShares MSCI Brazil Index (ETF) EWZ and Market Vectors Brazil Small Cap ETF BRF were down on Thursday.

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