Tombini Samba Rate-Cuts Out of Step With Investors Seeing Higher Inflation

Brazil’s central bank is cutting interest rates citing a novel forecasting tool called SAMBA that some economists say isn’t in step with the country’s inflation realities.

Policy makers, in justifying an interest rate cut last month with inflation at a six-year high, said they used the SAMBA model to craft the “base scenario” used to set monetary policy. It shows inflation slowing to the bank’s 4.5 percent target by the end of 2012, while models of the type used since 1999 show price increases above that level well into 2013.

The debut of the model comes as President Dilma Rousseff calls for lower rates and legislators from her Workers Party propose to broaden the central bank’s mandate to include supporting economic growth, instead of just targeting prices. Rousseff said last month that Brazil must keep “one eye on inflation, and the other on growth,” raising concern that policy makers are caving into pressure to keep cutting rates.

“If you look at the results from the standard model right now, they indicate absolutely no room to cut rates,” Tony Volpon, head of emerging markets research for the Americas at Nomura Holdings Inc., said by phone from New York. “It looks almost as if they have a result that they want and they are looking for the model to back it up.”
Surprise Cut

Brazil is the only Group of 20 nation besides Turkey to have trimmed borrowing costs in response to the European debt crisis. In August, central bank President Alexandre Tombini surprised all 62 economists in a Bloomberg survey by lowering interest rates 50 basis points to 12 percent even as inflation surpassed 7 percent. He lowered the benchmark rate another half- point last month.

While Turkey has since backtracked and raised one of its lending rates, Tombini has paved the way for more reductions. Last month, he said “moderate” rate cuts needed to counter a “substantial deterioration” in the world economy won’t affect the goal of bringing inflation to target in 2012. Traders are wagering the Selic may fall to as low as 9.75 percent by May, according to Bloomberg estimates based on interest rate futures.

The SAMBA, an acronym for Stochastic Analytical Model with a Bayesian Approach, is a Brazilian version of a new generation of models that are the subject of research by the U.S. Federal Reserve, the European Central Bank and the Bank of England.

Such models, called Dynamic Stochastic General Equilibrium models, or DSGEs, are “clearly the way of the future,” though they have not yet reached the point where they are a reliable guide for setting interest rates, said Marvin Goodfriend, a former Richmond Fed policy adviser.

“No prudent central banker would rely too heavily on a single approach to model monetary policy at this point,” said Goodfriend in a phone interview from Pittsburgh, where he teaches at Carnegie Mellon University. “I want to see a track record before I switch heavily to one or other model.”
Advanced Math

The SAMBA, which has 18 variables programmed into it, is being used to simulate the impact of the European debt crisis on Brazil, since it is good at capturing how external shocks spread through the economy, central bank board member Carlos Hamilton said in an interview in Brasilia.

Unlike the bank’s older models, which had seven variables, the SAMBA “has in its DNA some of the idiosyncrasies of the Brazilian economy,” Hamilton said. These include some consumers’ limited access to credit, the government’s fiscal targets and the inflationary impact of state-controlled prices.

“We will use this model at least while this highly complex situation lasts,” said Hamilton, who oversees economic policy at the bank.
Cutting Edge

The SAMBA has made the central bank’s rate moves harder to predict, since the model’s greater complexity means economists in the private sector cannot easily replicate its results, Volpon said.

Economists at Banco Bradesco SA, Brazil’s second-largest bank by market value, says they have managed to reproduce SAMBA’s 61 equations and said the model puts Brazil “at the cutting edge” of central bank technology.

Inflation expectations have jumped since the bank began easing monetary policy, a sign that economists don’t share Tombini’s view that the world crisis will be severe enough to cancel out domestic price pressures arising from near record-low unemployment and 20 percent credit growth. Analysts surveyed by the central bank expect prices to rise 5.57 percent next year and stay above the 4.5 percent target until 2014.
‘Smell Test’

Nobel Prize-winning economist Robert Solow testified before the U.S. Congress last year that DSGEs are based on “implausible assumptions” that don’t “pass the smell test.” While it’s OK for the research departments of the Fed and ECB to “experiment” with these models, he said they have a poor track record as a forecasting tool.

“One ought to be very skeptical,” Solow, a professor at the Massachusetts Institute of Technology in Cambridge, Massachusetts, said in a phone interview. “I don’t know how much credence they are putting in these things in Brazil, but if they are, I think they are not being critical enough.”

Brazil’s central bank earned a reputation among investors as a determined inflation-fighter, after conquering hyperinflation in 1994 that reached 4,923 percent and keeping inflation within its target range every year since 2003. Since Rousseff took office in January, she’s repeatedly pledged to lower interest rates that are the highest in the G-20 to “international levels.”
Rousseff’s Pledge

“As the financial crisis gets worse, this time we’ll take advantage of it,” Rousseff told businessmen on Sept. 30, referring to the bank’s four-month delay in lowering rates following the collapse of Lehman Brothers Holdings Inc. in 2008.

A Senate committee voted on Nov. 1 to approve a bill that would broaden the central bank’s charter to include fostering growth. Currently, Tombini’s mission is limited to targeting inflation and guaranteeing stability in the financial system.

While Tombini or Rousseff have yet to comment on the bill, Volpon sees it as an attempt to convert into law what SAMBA may already be doing in practice: allowing the bank to target economic growth. In the meantime, the bank’s inflation outlook is more benign than that of most analysts.

“It looks like the central bank is paying less attention to what market participants are telling them,” said Jankiel Santos, chief economist at Espirito Santo Investment Bank in Sao Paulo. “They are much more confident that they are right and the rest of the market is wrong.”