By Bruno Federowski

By Bruno Federowski

SAO PAULO (Reuters) - Investors are giving Brazil's central bank the benefit of the doubt for the first time in at least seven years, betting that slumping inflation will allow policymakers to cut the official target below the current 4.5 percent.

Two-year breakeven rates, a measure of market expectations for the official consumer price index, averaged 4.35 percent at Monday's close, data compiled by financial industry group Anbima showed.

Breakevens, the spread of yields on fixed-rate and inflation-linked government bonds, fell below the central bank's 4.5 percent target on Jan. 30 for the first time since records began in September 2009, and they have remained there.


Three-year breakeven rates are also hovering below the target, highlighting investors' growing trust in Central Bank President Ilan Goldfajn's ability to keep inflation at bay in Latin America's largest economy.

"The discussion of whether the central bank will meet the inflation target is over," said fixed-income trader Bruno Gouvêa of São Paulo-based brokerage Renascença DTVM Ltda. "The question now is whether we will have a lower target for years to come."

The National Monetary Council, comprised of Goldfajn and Brazil's planning and finance ministers, is expected to set the 2019 inflation target by the end of June. The bank has kept the midpoint at 4.5 percent since 2005.

Twelve of 20 economists in a January Reuters poll expected the council, known as CMN, to announce a lower target, with 10 forecasting a 4 percent midpoint.

That shows a sea change in investors' attitudes toward the central bank, which for years was accused of tolerating fast-rising prices to protect jobs and stimulate short-term economic growth.

Inflation, which has ended above the target in each of the last seven years, surged past 10 percent in 2015 but slowed to 5.35 percent in the 12 months through January.


The central bank's newfound credibility is raising hopes that Brazil may finally turn the page on decades of high inflation.

But skeptics say that will depend not just on monetary policy but on President Michel Temer's ability to pass a series of painful structural reforms ahead of a highly uncertain 2018 election.

Brazil's efforts to bring down the cost of living have long been hampered by laws linking government transfers, wages and controlled prices to past inflation, a legacy of rampant hyperinflation in the 1980s and 1990s.

Strict labor regulations also make it hard for companies to cut wages or fire workers, forcing them to resort to higher prices when costs increase.

Temer has made some efforts to reduce those pressures, passing a public spending cap in December and preparing pension and labor market reforms for this year.

It may prove an uphill battle, however, for an unpopular president dealing with a fragmented Congress and corruption accusations against senior members of his administration.

"Inflation in Brazil is very resilient; it's hard to picture it falling consistently below 4.5 percent," said Arnaldo Curvello, head of wealth management at Ativa Investimentos SA CTCV brokerage. "I don't really understand the reasoning that has driven breakeven rates so low."


Plunging inflation expectations have reduced breakeven rates dramatically in recent months.

Prices of fixed-rate LTN bonds maturing in July 2020 rose 8.3 percent in the last three months, driving yields nearly 2 percentage points lower to 10.3 percent.

At the same time, prices of inflation-linked NTN-B bonds maturing in August 2020 rose only 4.3 percent, with yields falling 0.7 percentage point to 5.48 percent.

Santander strategists say the move has already captured most of the impact of an expected cut in the inflation target. In a note to clients, they recommend switching to the inflation-linked bonds as "at least 70 percent of the rally is over."

The central bank lifted the benchmark Selic interest rate from a historic low of 7.25 percent in late 2012 to a nine-year peak of 14.25 percent in 2015. It now stands at 13 percent.

Goldfajn, a Massachusetts Institute of Technology-trained economist who took the helm of the bank last year, drew criticism for waiting to cut rates as the economy sank into its deepest recession ever.

Still, his efforts are bearing fruit now as inflation has undershot expectations for five straight months, facilitating the first rate-cutting cycle in four years.

Goldfajn has suggested that Brazil is on track for a target more in line with other emerging markets. Many, including Mexico and Colombia, aim for 3 percent annual inflation.

(Reporting by Bruno Federowski; Editing by Brad Haynes and Lisa Von Ahn)

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