MNI POLICY: Copom Dissenters Feared Reaction Function Misstep

The Brazilian central bank's deeply split decision to slow the pace of interest rate cuts to a quarter point this week likely reflected concerns among dissenters that the move could send the wrong signal to investors about policymakers' reaction function, MNI understands.

Market participants worried about the decision's political overtones after the four dissenting votes were cast by officials appointed by President Luis Inacio Lula da Silva, but there also appear to be significant policy wedges between the two camps. (See MNI INTERVIEW: Split BCB Vote Sends Political Message-Velho)

The debate centers around a speech from Governor Roberto Campos Neto at the IMF meetings last month seen as weakening the Monetary Policy Committee's guidance a month earlier.

At the time, markets were under stress because of a more hawkish Federal Reserve outlook and the change in the fiscal target for 2025, and Campos Neto said in Washington that he could slow down the pace of Selic cuts and that he was "not afraid to do what's needed", even though he had signaled a 50bp cut for May. Around that period, the dollar reached almost BRL5.30 but showed some improvement until the Copom meeting.

There is a perception that the BCB may have communicated to investors that this level of stress is enough to trigger Copom's reaction function. Between the last two board meetings -- from March 20 to May 8 -- the exchange rate went from BRL4.97 to BRL5.09, a relatively modest 2.61% appreciation of the dollar against the Brazilian real.

RISK OF ABANDONING GUIDANCE

The discussion at the Copom meeting between the two groups centered on whether it would be worth abandoning an already established guidance and reducing the pace -- which could bring a credibility risk -- when, in the central bank's econometric models, cutting 50bp or 25bp would not make much of a difference in terms of monetary easing. That is, if Copom has room to cut 50, according to the model, it wouldn't make a difference to cut by 25bp twice or just 50bp once.

Campos Neto spoke in Washington without consulting the entire board, including Gabriel Galípolo, a deputy who is slated to assume the BCB's presidency. In his speech, however, he gave the impression of speaking for the committee as a whole. Paulo Picchetti, one of the directors appointed by President Lula who voted with the doves for 50bp, was sitting beside him at the time. (See MNI INTERVIEW: Brazil Could Hike Rates In 2025 - Ex-BCB Serra)

NOT CLEAR HIERARCHY NOW

By weakening the guidance without consulting his colleagues, Campos Neto put himself in a difficult situation and led the longer-serving deputy governors, appointed by him or previously, to stand by his side in the vote. Before the central bank's autonomy in law, approved in 2021, the governor had the freedom to choose the deputies.

Now, because of fixed mandates interspersed with the term of the country's president, deputies from two different governments may have to coexist on the same board, as is happening now. As a result, the new deputies, who were not chosen by Campos Neto, do not see as strong a hierarchy relationship with the governor as their predecessors.

Minutes from this week's meeting, to be released Tuesday, will provide more details of the discussions inside an increasingly divided Copom. After the latest cut, the Selic rate now stands at 10.5%