Expect Brazil's politics to be a driver, but focus on inflation as fundamental risk

In this context, and in a scenario in which weak politics prevent a reasonably prompt consolidation of the core economic policy framework, it seems that investors should view inflationary developments over the next 3-12 months as a driver of the economic and financial outlook comparable in significance to politics, the terms of international trade, and world interest rates. If inflationary pressures ease significantly in the months to come, then market participants seem likely to view the Brazilian government's hypothetical ability (in extremis) to service local debt in locally manufactured currency as mainly reassuring (that the government will not run out of the currency that it needs to service debt) and only hypothetically worrisome (that it might create a disruptive inflation). In this respect, in a limited sense and for a limited time, Brazil could resemble Japan and the US, where massive central bank purchases of government debt have created neither inflation, nor the widespread anxiety that inflation may ultimately result. 

Another scenario is possible, in which inflation fails to come down as promptly as now expected and doubts grow about the central bank's ability to tighten policy to control it in a politically charged environment in which higher interest rates complicate already unstable public debt dynamics. If doubts intensify sufficiently, it is possible to imagine an expectations-driven inflation event that ends badly for Brazil and, potentially, its creditors.

The ongoing (and deepening) recession and the dissipation of price shocks from regulated prices and exchange-rate pass-through is expected to drive inflation from its now near double-digit level to less than 6% by the middle of 2016. As this occurs, the central bank will likely have space to bring interest rates down, and anxiety about monetary risks associated with the unsustainable policy framework should fade at least temporarily. This scenario would provide no permanent substitute for the fiscal consolidation that is, eventually, required to avoid some sort of public credit event. But it would likely, for better or worse, provide Brazil with potentially many months of space for the political conflict to play out. 

This happy ending is essentially what happened after the 2002 financial crisis and consequent recession. That is an encouraging precedent, and in some respects Brazil is better positioned to secure one now; hardly any of the public debt is in dollars, and the country has far higher international reserves. But the comparisons are not all encouraging. In 2003, the incoming government inherited a solid fiscal position and a well-developed monetary framework, and it enjoyed enormous popular support. Once market participants were convinced that the new government intended to preserve these central policies, the stage was set for economic and financial recovery. Today, key elements of the core economic policy framework have been undermined, and the question is as much about the incumbent government's ability to repair them as its intention.