### BRAZIL—INFLATION | ECONOMICS August 2, 2012

**ECONOMICS August 2, 2012**

BRAZIL—INFLATION

BRAZIL—INFLATION

FX weakness matters

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.

**Introduction**

The 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 correlation**

In 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 model**

We 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 IPCA**

According 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 IGP**

Our 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%.

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