"Behold this wonderful scenario..."

Year after year, interest rates remain the hot topic among economists, lawmakers, analysts, and, of course, taxi drivers! This year is no different, as the focus remains on how interest rates will evolve in major economies, especially in the U.S.—after all, we are talking about the world's largest power. It is worth remembering that interest rates are a pillar of any country's monetary policy and directly impact various sectors of the global economy. While some economies have already begun a rate-cutting cycle (see charts 1 and 2), others are moving in the opposite direction (hello, Brazil!), and in the U.S., the most likely scenario is a hold, though some uncertainty remains.

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It is worth noting that the U.S. Federal Reserve made a move to cut rates in its December decision late last year. However, the decline was interrupted in the first decision of 2025 due to persistent inflation and a still-heated economy, as we can see:

1. U.S. inflation does not seem to be letting up. The most recent indicators released in the U.S. have surprised to the downside once again. Both the PCE (Personal Consumption Expenditures Price Index) and the CPI (Consumer Price Index) came in higher than expected, showing annual inflation still above the 2.0% target. To put it in perspective, annual inflation measured by the CPI rose again in January of this year to 3.0%, compared to 2.9% in December. The core—which excludes food and energy—remained at 3.3% year-over-year, both well above the target. The core PCE also remains elevated (see chart 3).

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2. Economic activity, for its part, remains strong. Although U.S. GDP growth was lower in 2024 compared to 2023, it still exceeded initial expectations at 2.3% per year, with strong support from household consumption (see chart 4). Similarly, labor market indicators remain robust, signaling a still very heated economic environment. To put it in perspective, although the unemployment rate is high by U.S. standards (4.0%) and the number of job openings has slowed recently, we are still far from levels seen during a recession. Furthermore, initial jobless claims have been trending downward since October of last year. The same applies to PMI indicators, which remain above 50 points—a level that signals an expanding economy (see chart 5).

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Given these factors, the vast majority of forecasts are centered on a reduction of just 25 basis points for U.S. interest rates throughout this year, bringing the rate to the 4.25%–4.50% range by the end of 2025 (the current base rate is between 4.50% and 4.75%). It is worth remembering that, according to the Fed monitor calculated by investing.com, in mid-2024, about 50% of the sample indicated a sharper decline by the end of the year. However, more recent projections suggest only one cut, as mentioned above. There are also those who consider the possibility that the Federal Reserve will not make any further cuts throughout 2025, especially due to the new administration's trade and protectionist policies, in addition to other political and economic uncertainties.

The reader might be wondering what this whole discussion has to do with exchange rate behavior here in Brazil. And the answer for those who follow our content closely is the same as always. As long as U.S. interest rates remain at their current level, speculative investment flows will continue to be directed toward the U.S. Although emerging economies (hello, Brazil!) have more attractive interest rates, the U.S. economy is seen as safer. And interest rates between 5.00% and 5.25% in an economy viewed as safe are worth more than a 15.00% annual rate in an economy that still faces many challenges, especially on the fiscal front. Therefore, there are few arguments to ensure the inflow of dollars here. And if we don't have dollars (or have fewer of them), the exchange rate remains under pressure (see chart 6).

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Conclusion: for those who made it to the end of this reading, hoping and believing that the title of this report would live up to the content, you were mistaken. The "wonderful scenario" will remain just part of a famous samba song. In reality, the market projection, according to the Central Bank's Focus Report, indicates an exchange rate close to US$/R$6.00 by the end of the year. The expectation of sustained high interest rates in the U.S., combined with the uncertainties surrounding the Brazilian economy, especially in the political and fiscal spheres, should contribute to maintaining a high risk perception for Brazil. Not to mention that we will soon be approaching an election year. But that is a topic for the next carnival!

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