Monetary tightening and fiscal consolidation will help re-anchor Brazil inflation expectations

Monetary policy is being tightened aggressively in Brazil despite a contraction in economic activity. The BCB has already raised its benchmark rate by 275bp since Oct and will most likely keep going, as minutes from June's rate decision added that "determination and perseverance are needed to avoid the transmission of inflation to longer tenors". The market is pricing 100bp in additional hikes this year. We expect 50bp, with risks biased toward more hikes, said BofA Merrill Lynch

Surprisingly, the central bank is tightening monetary policy aggressively despite an economy already in recession: output contracted 1.6% YoY in 1Q15 and unemployment shot up to 6.4% in April from 4.3% in December. The BCB has clearly opted for the strategy of front-loading interest rate hikes to regain its lost credibility and re-anchor inflation expectations.

In addition to interest rate hikes, the government is tightening fiscal policy. While the government's target of a 1.2% primary surplus looks difficult to achieve, there should be a significant improvement from last year's 0.6% primary deficit. Market consensus forecasts a 0.8% primary surplus for 2015.

"We expect long-run inflation expectations will decline significantly given the assertiveness with which monetary and fiscal policy are being tightened. Current bond-implied inflation breakevens are close to 6.5%, almost 200bp above the 4.5% central bank's inflation target. Breakevens are likely to decline to at least 5.5% as the economy contracts, unemployment rises, public and private spending declines, and credibility is restored." said BofA Merrill Lynch