Simplified monetary policy
Dear investors,
It's curious how popular the discussion of monetary policy has become in Brazil, a highly technical and complex area even for market professionals. What everyone has already learned is that high interest rates reduce inflation and that the government's fiscal deficit increases inflation. Things get a bit more complicated when we hear that, even with inflation under control, the government still needs a greater commitment to fiscal responsibility to also control future inflation expectations. Otherwise, interest rates will remain high.
For those who aren't experts in macroeconomics and monetary policy, which is certainly our case, there's always the danger of getting lost in the jargon and abstractions, making it difficult to judge the coherence of what's being discussed. Complex and abstract arguments are more likely to mask errors. Therefore, we prefer simple and straightforward analyses, without embellishments or fanfare.
With this preference in mind, let's discuss what's happening with Brazilian monetary policy and how we deal with the situation in our investments, in the simplest way possible.
The SELIC rate and its impact on the real economy
A bank's basic function is to raise money in the market and lend it out at a higher rate. The difference between the interest paid on borrowing and the interest charged on lending is called the bank spread, and it is the main source of operating revenue for banks.
In this tangle of borrowing and lending, it's common for a bank to end the day with excess or insufficient cash, but banks are not allowed to end the day with a negative balance in their current accounts. To solve this problem, the Special Settlement and Custody System (SELIC) exists, which allows banks to lend money to each other for short periods, typically just one day, so that their accounts don't become negative at the closing of the day's cash balances. The interest rate charged on these daily loans is the SELIC rate, known as the basic interest rate because it is the return obtained from the lowest-risk credit operation in the country.
Initially, this rate could be freely set based on the supply and demand of capital in the market. However, the Central Bank operates within the SELIC by lending (or borrowing) money at the rate determined as the SELIC Target. Because the Central Bank participates in a significant portion of the total volume of these daily credit operations, the rate it charges serves as a strong benchmark for the entire market. This is how the Central Bank controls the national economy's base interest rate.
With the option of lending money to the Central Bank at the basic interest rate, it makes no sense to lend money to any company or individual at a lower rate. Since banks still need the bank spread to cover their operating costs and return on invested equity, all loans, with the exception of subsidized ones, are made at interest rates higher than the SELIC rate. In other words, when it rises, borrowing money in Brazil becomes more expensive.
The effect of rising interest rates is quite broad. Since most companies have some level of debt, they spend more on interest payments or repayments of these now more expensive debts, leaving less capital for investments in growth or innovation. Consumer credit also becomes more expensive, making it more difficult to finance any purchase, including retail purchases in 12 interest-free installments (i.e., cash prices with interest on 12 installments). The natural consequence is that domestic market demand declines, and, through the traditional mechanism in which prices are determined by the balance between supply and demand, prices tend to fall. This is how high interest rates help control inflation, with the side effect of hindering economic growth.
Fiscal responsibility, inflation and interest rates
Fiscal responsibility simply means the government spending less money than it earns. The rule is so universally applicable that it's strange that there's a long debate about whether the government should follow it. The situation becomes more understandable when we consider the practical perversities of politics.
A government that spends recklessly during its term generates a deficit but gains popularity by delivering social projects and programs, just as a reckless consumer happily enjoys their purchases until the credit card bill arrives. The point is that, for the ruler, the "credit card bill" can be postponed until the next term. Whoever inherits the government will have a problem on their hands: either they restrict spending to rebalance public finances, an always unpopular measure, or they further exacerbate the problem by maintaining the deficit. If the decision to restrict spending comes from an opposition leader, the person responsible for the debt incurred during the previous term will still make comparisons, claiming they delivered much more to the population during their term, without addressing the damage caused to public finances in the process. Political frustrations aside, let's look at what happens when the government increases its spending.
Due to the large size of the government, when it spends more, the total domestic market demand for goods and services increases significantly, generating upward pressure on prices, due to the same supply-demand balancing mechanism we discussed earlier. In other words, increased government spending contributes to higher inflation.
A second problem is that fiscal deficits force the government to inevitably increase public debt. If this regime continues for too long, there comes a point at which the government can no longer afford the interest on the debt or issue additional debt, as there will be no longer any interest in lending even more money to a government that consistently ends up in the red. In this situation, two options remain: the government declares a moratorium, an extreme measure in which payments related to the public debt are suspended, causing enormous damage to the country's reputation; or it can issue more currency through the central bank and use it to pay off the debt. Some see this second solution as a magic formula for solving the problem. However, since it is not possible to generate economic value out of thin air, simply printing more currency only causes the same quantity of goods a country has to be represented by a greater volume of money, and thus the value of the monetary unit decreases, causing nominal prices to rise. This is a second way to generate inflation.
There is another negative effect. Recurrent deficits cause investors to lose confidence in the sustainability of public finances. This lack of confidence reduces the inflow of foreign capital and, therefore, also reduces the volume of purchases of local currency. Besides the obvious problem of receiving fewer investments, the lower demand for reais causes our currency to devalue, and exchange rates become less favorable for imports. In other words, the dollar rises, and the price of everything imported increases. Since a significant portion of Brazilian consumption comes from imported products (approximately 20%), the rise in the dollar also increases inflation.
Meanwhile, the Central Bank's role remains to control inflation through the only tool at its command: monetary policy. Thus, the larger the fiscal deficit, the greater the inflationary effect, and the more the central bank will tend to raise (or maintain) the benchmark interest rate.
Where complexity arises
If these mechanisms could be analyzed in isolation, it wouldn't be such a difficult task to understand the situation and project likely developments. However, they all act simultaneously on the economy and have effects beyond those predicted by the simplified mechanics we've described. For example, raising interest rates initially reduces inflation, but it makes it more difficult to balance public finances, as it increases government interest rates and reduces economic growth, thus reducing tax collection. Since a fiscal deficit increases inflation, the side effect of raising interest rates can worsen the inflation problem in the medium term, just as an overdose of medication does more harm than good. Calibrating the ideal interest rate isn't an exact science. The Central Bank uses mathematical models to calculate the neutral interest rate—one that would neither accelerate nor decelerate the economy—and adjusts its monetary policy accordingly. However, the model is theoretical, and the real effect can only be known through good old-fashioned trial and error. That's why the Central Bank changes interest rates gradually. Go up 0.25% and wait to see what happens. Go down 0.25% and wait to see what happens.
There's also the issue of expectations. Although subjective, their impact on the economy is real. When business owners and investors believe future inflation will be high, they incorporate this assumption into their calculations and make business decisions accordingly. They raise the selling prices of their products, anticipating increases in their production costs, and demand higher rates of return on their investments to offset the risk associated with inflation (e.g., costs rising more than can be passed on in prices). Thus, actual inflation tends to converge toward expected inflation, in a form of self-fulfilling prophecy.
In turn, inflation expectations are guided by what the market expects the Central Bank and the government to do over time, as they are the agents with real power to significantly influence the economy. When both act consistently and in a coordinated manner, the scenario is more stable. When they act erratically and there is friction between the government and the central bank, what we are experiencing in Brazil happens. No one knows for sure what the future will hold, and expectations also fluctuate erratically.
What to do in investments
In complex and unstable scenarios, we prefer to embrace uncertainty in its full scope rather than overestimate our ability to predict the future. All this discussion surrounding fiscal responsibility, monetary policy, inflation, and interest rates creates a complex and unstable scenario. So, instead of trying to project (or guess) COPOM's next decision on the SELIC rate and its impact on inflation, we seek to position ourselves in investments that tend to generate a good rate of return regardless of the exact path that interest rates and inflation take over the years.
We frequently repeat in our letters what these investments are: shares in good companies with sustainable competitive advantages, a history of high profitability, and a resilient business model. Such companies are often able to survive and thrive because they generate real economic value. They will advance faster when the macroeconomic scenario is favorable and will resist as well as possible when it is unfavorable. Over long periods, they tend to generate good average returns on the capital invested in the operation.
We acknowledge the uncertainties of macroeconomic variables and avoid investing time trying to project what cannot be predicted with sufficient accuracy to support an investment thesis with good return potential and controlled risk. We prefer to spend our days monitoring the companies in our portfolio, evaluating other listed companies, and studying the microeconomic cycles of sectors that capture our attention.
Our strategy is simple in essence. We seek to identify listed companies that possess the aforementioned characteristics, calculate a fair value for their shares, assuming a very conservative scenario for the points we cannot accurately predict, and wait until an opportunity arises to buy them at a price low enough to make the investment reasonably profitable even in this pessimistic scenario. Anything above that is profit. Literally.
