Economic Analysis - Cautious Rate Cuts Amid Looser Inflation Targets - MAR 2018


BMI View : The Banco Central de la Republica Argentina will cut interest rates cautiously over the coming year, aiming to ensure disinflation remains on track. Looser inflation targets are unlikely to alter the pace of rate cuts , though they pose downside risks to market participants' expectations.

  • The Banco Central de la Republica Argentina (BCRA) will cut interest rates at a relatively gradual pace over the coming year in response to disinflation and elevated real rates.

  • However, we have upwardly revised our end-year interest rate forecast in light of an upward revision to our inflation forecast. We now forecast the policy rate at 22.75% by end-2018, up from 20.25% previously, and 16.75% by end-2019.

  • We now forecast inflation to fall to 16.1% y-o-y at end-2018, up from 15.3%, averaging 20.5%. A planned series of public utility tariff hikes over the coming months will keep inflation elevated, although core inflation will moderate.

  • The BCRA's looser inflation targets are unlikely to substantially alter monetary policy decisions, although the effect on expectations is as yet unclear.

The BCRA will remain in a rate cutting cycle over the coming quarters. On January 9, the bank cut its benchmark policy rate by 75 basis points (bps), to 28.00%, a shift in policy direction that comes in line with our view ( see 'Hawkish Stance To Bring Down Inflation Expectations', November 1 2017). Even against elevated inflation, we estimate real rates at above 12.0%, higher than they were when the BCRA initially attempted to begin easing rates at May 2016. Though the bank subsequently described its previous easing as premature, elevated rates pose a headwind to Argentina's still-nascent economic rebound, and market participants have already priced in cut expectations.

Inflation Remains Stubbornly High
Argentina - Monetary Policy & Inflation
Source: BCRA, INDEC, BMI

Inflation will decelerate over the coming months but remain elevated. At 24.8% y-o-y in December, inflation exceeded both the BCRA's 17.0% upper target and our 22.1% forecast. Utility rate hikes were the single largest driver of inflation over the last year, jumping 55.6% as the government cut end-user subsidies in order to reduce expenditures and unwind market distortions. Scheduled hikes over the coming months will underpin cost growth, though we expect the marginal impact of these hikes will be reduced. Additionally, seasonal and core price growth have been far more contained, which we expect will continue.

Nonetheless, visibility into BCRA policymaking has weakened over recent months. The bank has struggled to establish the credibility of its inflation-targeting regime against increasingly visible signs of tension with the rest of President Maurico Macri's economic team. In October and November, the bank surprised markets, and our expectations, by enacted two 100bps rate hikes aimed at reigning in rising inflation expectations. However, in late December the bank capitulated to pressure from the government and raised its inflation targets for 2018 to 15.0%, up from 8.0-12.0%, and for 2019 to 10.0%, from 3.5-6.5%.

We do not expect the looser inflation targets to substantially alter the pace of the BCRA ' s rate cuts. The new targets are closer in line with existing consensus forecasts, including our own. Moreover, January's cut was less than many market participants anticipated in response to the target change, suggesting that the bank remains committed to reining in inflation. Given that the BCRA has now managed to surprise market expectations three times in as many months, each time by pursuing tighter monetary policy than the market had anticipated, we anticipate a relatively modest pace of rate hikes over the coming quarters.

Nonetheless, looser inflation targets could lead to higher inflation expectations among market participants. That could lead to larger increases in contracted prices, such as union wage negotiations, over the coming quarters and, in turn, lead to higher inflation than we currently forecast.

FX Rate Likely To Weaken Further
Argentina - Exchange Rate, ARS/USD
Source: Bloomberg, BMI

Additionally, we see substantial downside to our exchange rate forecasts. The Argentine peso sold off drastically after the BCRA announced its looser targets, breaking into new lows. While we had expected modest nominal appreciation over the coming months due to aggressive monetary policy ( see 'ARS: High Real Rates Support Modest Appreciation', November 30 2017), higher inflation and an upward revision to our US interest rate forecasts ( see 'Six Reasons For Three Fed Hikes In 2018', January 5) have made nominal appreciation look highly unlikely. As a result, we will be reassessing our peso forecasts in the coming days.