September 27, 2016 / 12:05 PM / 3 years ago

UPDATE 3-Brazil central bank sees inflation down, signals rate cut

(Adds central bank director comments)

By Alonso Soto

BRASILIA, Sept 27 (Reuters) - Brazil’s central bank expects annual inflation to ease below the government’s 4.5 percent target in 2017 after years of hovering well above that goal, leaving the door open for cutting some of the world’s highest interest rates as early as October.

In its quarterly inflation report released on Tuesday, the bank lowered its 2017 inflation forecast to 4.4 percent from 4.7 percent. For 2016, the bank raised its outlook to 7.3 percent from 6.9 percent.

It said it expected annual inflation to drop to 3.8 percent in 2018.

“The report consolidated the idea that the bank will cut rates in October,” said Otavio Luis Leal, chief economist with Banco ABC Brasil in Sao Paulo. “Now the question is: by how much.”

Leal said inflation data from the bank’s new hybrid forecasting models pointed to a rate cut next month.

“The approval of the spending ceiling proposal will be key for the bank to decide on 25 or 50 basis points in October,” he added.

In October, a special commission in the Lower House is expected to vote on a proposal to cap public spending. This may show the level of resistance that President Michel Temer, who has introduced legislation to reduce the country’s soaring debt burden and regain investors’ confidence of investors in the once-booming economy, will face in Congress.

Yields on Brazil’s interest rate futures indicate a probability of 78 percent that the bank will cut rates by 25 basis points at its Oct. 18-19 meeting.

Since July 2015, the central bank has kept its benchmark Selic rate steady at a 10-year high of 14.25 percent to battle inflation that remains near 9 percent, almost double the official target.

Carlos Viana, central bank director of economic policy, told reporters later on Tuesday that the relevant horizon for monetary policy is not static, meaning policymakers will aim to keep inflation at target beyond the year-end goal set by the government.

In the report, the bank said it saw signs that food prices were easing, but the pace of the inflation slowdown and the implementation of key fiscal reforms remain uncertain. Those three factors are crucial for the future of monetary policy, the bank has said.

The central bank aims to keep inflation at 4.5 percent, the center of the official target range. Since 2010, it has missed that target despite a crippling two-year recession that has slashed demand from consumers and businesses.

In a hybrid model that uses the market forecasts for interest rates and keeps the exchange rate constant, the bank sees inflation at 4.8 percent next year.

A second hybrid model that keeps rates on hold and adopts market forecasts for the exchange rate shows inflation hitting the target in 2017.

For Alessandra Ribeiro, partner with Sao Paulo-based consultancy Tendencias, that inflation resistance could keep the bank from raising rates in October.

“I will expect further changes in those projections for the bank to act,” Ribeiro said. “I only see marginal changes to the bank’s projections, and the cautious tone remains.”

The bank held its estimate for an economic contraction of 3.1 percent in 2016, but it expects the economy to grow 1.3 percent in 2017. (Reporting by Alonso Soto; Editing by Lisa Von Ahn and Alan Crosby)

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