BRAZIL—INFLATION | ECONOMICS August 2, 2012
Autor: Daniel Brandão de Castro | Publicado: 2012-08-02T17:04:00-03:00


ECONOMICS                                                 August 2, 
2012

BRAZIL—INFLATION

FX weakness matters  - FX weakness matters: 
This time pass-through to IPCA should be higher than in 2008/2009, as the 
economy is stronger, initial inflation is higher, and a significant monetary 
stimulus is under way. - We estimate that recent BRL depreciation will have 
an impact on IPCA inflation of 0.5 p.p. this year and 0.38 p.p. next year. - 
We maintain our IPCA forecasts at 5.0% and 6.0% in 2012 and 2013, on the 
reduction of taxes on durable goods and on tax redemption expectations for 
2013. - We are raising our forecast for 2012 and 2013 IGP-M to 7.0% and 
6.5%, respectively. IntroductionThe 
pass-through coefficient is defined as the response of accumulated inflation to 
exchange rate nominal depreciation. Although other economic variables also 
influence the relationship between inflation and currency weakening, this note 
presents our estimate of the effects of the pass-through of the exchange rate to 
the consumer price index (IPCA) and to the industrial wholesale price index (IPA 
industrial) outcomes.In IPCA’s pass-through exercise, we considered the 
following as economic variables that also influence the relationship between the 
consumer price index and currency weakening: (1) the price level: a high 
inflation backdrop tends to produce higher exchange rate pass-through; (2) 
output gap: the business cycle also matters in the pass-through to inflation, as 
above-trend growth tends to increase the pass-through coefficient; (3) real 
effective exchange rate: REER overvaluation or undervaluation can limit or 
amplify the pass-through effect; and (4) trade openness: the correlation between 
inflation and openness is negative; however, the more open the economy, the 
higher the degree of pass-through; in other words, the more open the economy, 
the greater the sensitivity of domestic inflation to inflation 
abroad.Our wholesale price index pass-through exercise focuses on the 
industrial wholesale price index (IPA industrial) instead of on the total 
wholesale price index (IPA) because the former is composed entirely of tradable 
goods, while the latter includes the agricultural price index, which includes 
some nontradable goods. Moreover, IPA agricultural is mainly driven by harvest 
and domestic weather problems, and these factors affect the final pass-through 
coefficient estimate.  For our IPA industrial’s pass-through exercise, 
we included the following as economic variables that also influence the 
relationship between the industrial wholesale price index and currency 
weakening: (1) the price level; (2) output gap; (3) trade openness; and (4) 
commodity prices: raw material goods prices affect industrial goods 
prices.Historical correlationIn the last eight years, several 
periods of fast exchange rate depreciation exerted pressure on inflation. 
Nevertheless, the final impact of BRL depreciation on market prices inflation 
(IPCA) or IPA industrial was different in each period, as can be seen in the 
table below. For example, comparing the accumulated depreciation in 2004 with 
that in 2008, the importance of the business cycle and the initial inflation 
rate on the final FX pass-through to market prices inflation is clear. The BRL 
weakening between January and May 2004 (around 11%) had a higher impact on 
market prices inflation than the effect of BRL depreciation between August and 
October 2008, despite the FX rate having jumped much more in the latter period 
(around 60%). Regarding the FX pass-through to industrial wholesale prices, the 
GDP performance and commodity prices seem to be more important than the initial 
inflation rate.It is worth noting that in 2004, GDP growth was 5.7%, and 
inflation in the prior year was 9.3%, while in 2008/2009, GDP growth ran at 
-0.3% while inflation in the prior year was 5.9%.Focus on market prices 
inflation: we expect a higher pass-through of the current BRL weakening (18%) 
than observed in 2008/2009, ceteris paribus. This is based on the economy 
growing faster (1.9%), the initial inflation being higher (6.5%), and a 
significant monetary stimulus (the real interest rate is below 2%) being under 
way in order to further stimulate domestic demand. The modelWe 
define the pass-through as the relationship between accumulated market prices 
inflation (market prices inflation and industrial wholesale prices inflation) in 
n periods and the exchange rate depreciation also accumulated in n-th period, 
but lagged by one month in order to allow inflation’s response to a change in 
the exchange rate. Our IPCA pass-through exercise focused on measuring 
the pass-through to market prices inflation, which represents 76% of IPCA. To 
control the effects of the business cycle, real exchange rate, initial 
inflation, and trade openness on the exchange rate pass-through to market prices 
inflation, the model also considered as explanatory variables the GDP deviation 
from trend, which was constructed using the Hodrik-Prescott (HP) filter; the 
REER deviation from trend, that was also constructed using the HP filter; the 
initial inflation (market prices inflation) lagged by one month; and trade 
openness, measured as the sum of exports and imports as a percentage of GDP 
(accumulated in 12 months). In this approach, we ran a Generalized Method of 
Moments (GMM) model to measure the pass-through coefficient, controlling for 
“endogeneity” problems, which occur when the economic variables are mutually 
dependent, as is the case here. The estimates for the pass-through to inflation 
in 3, 6, 9, 12, and 15 months are presented in the table below.As expected, 
according to our exercise, in the very short run the effect of BRL depreciation 
on inflation does not seem statistically significant and the sign was different 
than expected. Moreover, REER, output gap, and openness are not significantly 
different than zero. Only initial inflation is statistically significant, 
in-line with macroeconomic theory. Looking six months ahead, the pass-through 
coefficient reached 3.5%, and the business cycle, initial inflation, and 
openness variables are significantly different than zero and with the expected 
signs. For 9 and 12 months ahead, the pass-through coefficient reaches its limit 
between 4.5% and 11.0%, where most of the other relevant variables appear with 
the expected signs and are significantly different than zero. After 12 months, 
the pass-through coefficient decreases and becomes statistically not 
significant.In our wholesale price index’s pass-through exercise, to control 
the effects of the business cycle, initial inflation, trade openness, and 
commodity prices on the exchange rate pass-through to industrial wholesale 
prices inflation, the model considered as explanatory variables the same 
variables used in the IPCA’s pass-through exercise except REER, and included the 
commodity prices variation, which was constructed using the same method of the 
exchange rate depreciation—accumulated in n-th period, but lagged by one month 
in order to allow inflation’s response to a change in commodity prices. We also 
ran a Generalized Method of Moments (GMM) model to measure the pass-through 
coefficient, controlling for “endogeneity” problems, which occur when the 
economic variables are mutually dependent, as is the case here. The estimates 
for the pass-through to inflation in 1, 6, 9, 12, and 15 months are presented in 
the table below.As expected, according to our exercise, in the very 
short run, the effect of BRL depreciation on inflation is relevant and does seem 
statistically significant, with the expected sign. Moreover, the output gap, 
initial inflation, and openness are significantly different than zero. Only the 
commodity prices are not statistically significant. In the model looking six 
months ahead, the pass-through coefficient climbs to 18.8%, and the business 
cycle and openness variables are significantly different than zero and with the 
expected signs. For 12 months ahead, the pass-through coefficient reaches its 
limit at 44.5%, where most of the other variables considered appear with the 
expected signs and are significantly different than zero. After 12 months, the 
pass-through coefficient decreases and becomes statistically not 
significant.Effects on IPCAAccording to our baseline scenario 
that considers no economic disruption in the advanced economies, we believe that 
the pass-through coefficient to market prices inflation is between 4.5% and 
11.0% of the cumulative BRL depreciation in a 12-month horizon. This means that 
the recent BRL weakening of 18% would have a total impact of 1.1 p.p. on the 
IPCA, of which 0.62 p.p. would occur this year and 0.48 p.p. in 2013. 
Nonetheless, we expect some BRL strengthening in 4Q12, which would reduce 
the total BRL depreciation in the year (15%); therefore, we estimate that the 
total impact of BRL depreciation on IPCA will be 0.88 p.p., of which 0.5 p.p. 
should occur this year and 0.38 p.p. in 2013. Even so, we maintain our forecast 
for IPCA at 5.0% in 2012, basically considering the reduction of taxes on 
durable goods (cars, household appliances, and furniture). We also maintain our 
forecast for 2013 IPCA at 6%, expecting some tax redemption for some regulated 
prices (tariffs) in the next year.Effects on IGPOur exercise 
indicates that the pass-through coefficient to industrial wholesale price 
inflation is around 44.5% of cumulative BRL depreciation in a 12-month horizon. 
Thus, taking into account the recent BRL depreciation of 18%, the impact on IPA 
industrial should be 7.8 p.p., which means a final impact on IPA (that includes 
agricultural prices) of 5.5 p.p., and 3.3 p.p. on IGP-M. Likely, 1.9 p.p. would 
occur this year and 1.4 p.p. next year. In this exercise, we did not consider 
the impact of BRL depreciation on CPI—that also composes the IGP-M, weighting 
30% of total. If we consider the same pass-through coefficient found for IPCA’s 
market prices inflation, we can add 0.3 p.p. on IGP-M, of which 0.2 p.p. would 
occur this year and 0.1 p.p. next year. According to our baseline 
scenario, some BRL strengthening should happen in 4Q12; therefore, considering 
BRL depreciation in the year of 15%, the impact on IPA is 4.6 p.p., and on IGP-M 
it is 2.8 p.p. Accounting for the CPI’s effect, the impact on IGP-M is 3.0 p.p., 
of which 1.8 p.p. would occur this year and 1.2 p.p. in 2013. Consequently, we 
are revising our forecast for 2012 IGP-M to 7.0% from 4.9% and for 2013 IGP-M to 
6.5% from 5.0%.