Brazil Real's depreciation to test BCB stance irrespective of near-term rate decision

The BCB is set to raise the Selic rate by another 25bp at its September Copom meeting and then to go on hold. The immediate downside risk, going by the July Copom statement, is that it has already concluded the tightening cycle. Meanwhile, the deterioration of the economy and fiscal situation has led to substantial depreciation of the BRL. Clearly, there is a deep disconnect between the monetary policy and the fiscal stance.

In the absence of meaningful positive shocks (trade and reforms in particular), painful adjustments will continue to take place through financial market developments. Hence, the BRL will remain under pressure, raising inflation expectations. This will test the BCB's stance even if it decides to take a pause at the September Copom meeting or has already stopped tightening.

The market's interpretation of the extended statement released after the last Copom meeting is that the time is approaching for the BCB to end its tightening cycle, which started in April 2013 and has seen 700bp added to the Selic rate (currently at 14.25%). The key addition to the BCB's usual short post-Copom meeting statement in July was: "The Committee understands that the maintenance of this basic interest rate level, for a sufficiently long period, is necessary for the convergence of the inflation to the target at the end of 2016."

"We do not necessarily find this view to be wrong, as the last pause, beginning in May 2014 and lasting until October 2014, followed another surprise addition to the April Copom statement. With the economy set to contract by over 2% this year, medium-term growth expectations plummeting fast (the economy is also likely to contract next year) and the labour market deteriorating, the BCB may find it difficult to avoid taking the middle path between growth and inflation. Therefore, we do see substantial downside risk to our call of a 25bp rate hike at the September Copom meeting", says Societe Generale.