GDP is projected to grow by 2.8% in 2022, 1.2% in 2023, and 1.4% in 2024. Household consumption, private investment and exports will remain the main drivers of growth, although quarterly export growth is projected to slow in 2023. Household spending is buoyed by higher social transfers and vigorous employment growth but will also ease next year. Private investment will continue to rise on the back of improving business confidence. Despite higher global interest rates, the exchange rate has appreciated slightly this year, attenuating inflationary pressures. Inflation is projected to decline over the projection period as the effects of higher energy and food prices fade.
Monetary policy is expected to remain restrictive, with the current policy rate of 13.75% unchanged until mid-2023. Policy interest rates can be lowered once inflationary pressures recede further. Fiscal policy has been expansionary and has contributed to inflationary pressures by raising demand. A comprehensive consolidation strategy is needed to reduce the deficit and restore the credibility of the fiscal framework. Reducing budget rigidities and limiting mandatory government spending would improve spending efficiency. Better managing public infrastructure investment, reforming social transfers, and stronger sustainability incentives for the agricultural sector could boost potential growth while improving public finances. Further developing the energy mix would reinforce resilience to climate shocks.
Economic activity accelerated in the first and second quarters with higher-than-expected growth of 1.1% and 1.2% (quarter-on-quarter) respectively. However, growth weakened in the third quarter. Monthly indicators point to a slowdown of activity in mining, though indicators are more mixed in manufacturing. The headline figure for manufacturing points to a small aggregate decline driven by intermediate and non-durable goods, but most manufacturing sectors kept growing. Moreover, capacity utilisation in the manufacturing sector has increased to over 80%, confirming a broad-based manufacturing recovery. Services expanded strongly in August for a fourth consecutive month, driven by household services and information and technology, though transport services have been declining. The services sector continues to be the main driver of GDP growth on the supply side, partly still reflecting pent-up demand from the lifting of mobility restrictions. Broad retail sales declined in the third quarter as real wage growth levelled off, household credit decelerated and the savings rate normalised.
Headline inflation has receded from 11.9% year-on-year in June to 6.5% in October, but core inflation remains high at 8.2% in October. Inflation expectations have fallen to 4.7% and 4% for 2023 and 2024 respectively. The decline of headline inflation is mainly due to falling international oil prices and significant tax relief, including a cap on the rate that subnational governments can apply for the largest consumption tax, in addition to reductions and exemptions from federal taxes. These measures effectively reduce the tax burden on fuels, electricity, natural gas, communications and public transport. They have also curtailed states’ tax revenues, which cooled off in July, rising by only 1.2% compared to 4.5% until June. The labour market has improved as economic activity gathered momentum. The unemployment rate declined from 11.1% in March to 8.7% in September, as job creation remained vigorous. Average real labour income rose by 2.5% year-on-year in September.
The Central Bank of Brazil is expected to maintain the policy rate at 13.75% until mid-2023. Given ongoing monetary policy tightening in advanced countries, which will exercise pressures on the exchange rate, the policy rate should not start declining until trend inflation is on a persistently declining trajectory. Starting from mid-2023, policy rates are expected to be reduced to 10% by the end of 2024.
Fiscal policy has been expansionary in 2022, propelled by tax exemptions to cope with higher energy prices and a 50% increase in the size of the social transfer programme Auxílio Brasil. Both policies are currently set to expire in December 2022, although the increase of the social transfer programme will likely be maintained. This would cost around 0.5% of GDP, similar to the cost of a continuation of the tax exemptions, after adjusting for their likely growth impact. However, maintaining both measures will be hard to reconcile with the fiscal rules and with the need to move towards a more restrictive fiscal policy stance to reduce the deficit and contain public debt from 2023 onwards.
A deteriorating global outlook, tighter fiscal policy and the effects of higher interest rates will reduce GDP growth from 2.8% in 2022 to 1.2% in 2023, before a slight improvement to 1.4% in 2024. Lower commodity prices and the slowdown in major trading partners will reduce external demand. Tighter credit conditions will limit household consumption along with a slowdown in job creation in 2023. As supply bottlenecks fade and the gradual effects of higher policy rates materialise, inflation is projected to decrease from a year average of 8.9% in 2022 to 4.2% in 2023, but to edge up to 4.5% in 2024 as growth picks up, at the upper end of the 1.5-4.5% tolerance band around the inflation target of the central bank for 2024.
Risks to inflation are tilted to the upside as most of the inflation decline is coming from administered prices such as fuel prices, while market prices, though rising less quickly for industrial goods, remain dynamic in the services sector. Moreover, the tight labour market might keep services inflation and other cyclical prices higher for longer, particularly if real wages start to rise. Uncertainties around future fiscal policy might unsettle financial markets, requiring the central bank to maintain high policy rates for longer, which would weigh on growth.
Compliance with the current fiscal framework is becoming increasingly difficult due to the inherent conflict between a fiscal rule that limits the increase of government spending and budget rigidities, as mandatory spending rules affect around 92% of the budget. A reform reducing automatic spending requirements, together with a stronger fiscal framework, could provide some relief for fiscal policy. Brazil already has a relatively clean energy mix, with 86% of electricity sourced from hydropower and biomass and 45% of its energy from renewables. The strong reliance on hydroelectric energy has shown limits in 2021 when droughts lowered reservoir levels, calling for stronger investment in other renewable sources. Wind and solar sources present significant untapped potential. Public investment in infrastructure in Brazil is low compared to the OECD and peers and it has declined over time. Large infrastructure gaps exist in transport, water, and sanitation. Scaling up investment in high-quality and broadly accessible infrastructure would raise productivity and potential growth and contribute to climate mitigation and adaptation.
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