All these three forces were at play in Latin America in the first decade of this century, but it is hard to tell apart their individual effects (Lustig, Lopez-Calva and Ortiz-Juarez (2013) and importance. My view on this, though, is the following:

(a) The rise in average schooling was probably an important driver of lower inequality. But average years of education of the labor force (15 years old and more) in Latin America increased by 1.23 year in the 1990s, against a more modest rise of 1.07 year in the 2000s.[vii] Moreover, educational inequality declined in both decades by a similar amount – 2 percentage points in the Gini coefficient (World Bank, 2012). It seems hard to reconcile this with the fact that income inequality rose in the 1990s and declined in the 2000s. At the very least, it was not only education.

(b) The deterioration in the mean quality of tertiary education is consistent with anecdotal evidence from Brazil. It is explained by a combination of supply expansion concentrated on private, lower quality education and a decline in the average quality of students entering university. This hypothesis could in principle be tested by looking at the dispersion of wage premia amongst university graduates.

(c) The change in the composition of labor demand is also consistent with evidence from Brazil. Thus, almost all the acceleration in output growth between 1998-2004 and 2005-11 was due to faster growth in financial intermediation, construction, commerce, transportation, public utilities and other services. That is, non-tradable sectors that are mostly intensive in low-skilled labor (compared, for instance, with manufacturing, whose share in total employment declined).

Both growth and the decline in inequality have slowed down since 2010, signaling more modest reductions in poverty in the future. In particular, after dropping continuously between 2001 and 2010, Latin America’s Gini coefficient has stalled around 0.52 percent after 2010. As the commodity boom recedes and countries strive to lower their external imbalances, it is likely that their exchange rates will weaken further, so that resources move from nontradable to tradable sectors.

This will limit the scope for lowering inequality as it was done in last decade. Further reducing education inequality may be a way to counter the effect of the economic slowdown and the restructuring of demand. But, in my view, more will have to be done. In particular, I believe that two issues will enter the agenda.

First, but possibly more difficult, is adopting less regressive taxes. Thus, while government transfers help reduce inequality, taxes overall raise it, so that at the end of the day fiscal policy has only a modest role in improving distribution in Latin America. This is shown in Table 3, where I report the difference between the Gini coefficient calculated before taxes and transfers and afterwards. Thus, fiscal policy has a relevant contribution to lower inequality only in Brazil, Guatemala and Uruguay. Even in these cases, though, this contribution is much lower than in developed countries. And this feature has not changed over the last two decades.

Table 3: Difference between market Gini and net income Gini¹ (in percentage points)

Source: Soltz (2013).[viii] (*) Last year is 2012; (**) 2010; and (***) 2006.

(1) Net income Gini accounts for taxes and government transfers.

Second, enlarge and improve the provision of basic public services, which go disproportionately to the poor. Thus, when one accounts for the provision of public services, notably public health and education, the Gini coefficient falls substantially. According to Lustig, Pessino and Scott (2013), the Gini coefficients of Argentina, Bolivia, Brazil, Mexico, Peru and Uruguay decline by, respectively, 8.8, 6.0, 9.1, 4.4, 2.0, and 6.3 percentage points when in-kind transfers are monetized and counted as sources of income.[ix] I would speculate that public housing programs, such as Minha Casa, Minha Vida in Brazil, have similar effects.

Today IBGE, Brazil’s statistics bureau, released the national accounts for the 2^nd quarter of 2013. At 1.5% quarter on quarter (qoq), seasonally adjusted (sa), GDP growth came at the top of the range of forecasts published by market analysts, which were on average around 1%. As in the 1^st quarter, when the economy expanded a more meager 0.6%, agriculture and investment led the expansion. In the output side, both industry and services performed surprisingly well. In the demand side, the main surprise was the significant positive contribution of net exports, reversing the terrible result in the 1^st quarter. Consumption growth, on the other hand, remained subdued, at 0.3%.

The results for the 2^nd quarter show a much overdue rebalancing of the economy, towards more investment and less consumption, as well as a lower reliance on the expansion of net imports. Likewise, it is positive that agriculture and industry are the leading sectors, while growth in the more labor intensive services sector falls behind. Should one read these results as signaling that the Brazilian economy is entering a healthier growth track? Yes and no.

Agriculture, manufacturing and investment performed poorly in 2012, contracting respectively 2.3%, 2.5% and 4.0%. It is only reasonable that they bounce back this year. Performance in agriculture should remain strong, given Brazil’s competitiveness, the weather permitting. The weakening of the real will help manufacturing in the medium term. In the short term, though, it will affect the sector negatively, given its reliance on imported inputs and the difficulty to pass along cost increases, due to the weakness in consumption.

As we move into 2014 investment growth will likely come down, with rising interest rates and economic and political uncertainty. It is difficult to predict by how much, for this will depend on the strength and effectiveness of economic policy. It is noteworthy, in this sense, that while in the 1^st quarter the rise in investment was due almost entirely to a greater absorption of capital goods, with construction performing weakly,  in the 2^nd quarter construction took the lead. In the 1^st quarter, in addition to the need to transport the agricultural crop to the ports, the acquisition of capital goods was boosted by the highly subsidized credit provided by BNDES to the acquisition of capital goods. In the second quarter, in turn, it was the expansion in housing credit by government banks that boosted construction.

I expect the rest of 2013 to show much weaker GDP figures than those of the 2^nd quarter. Declining consumer and business confidence, rising interest rates, contracting credit concessions and the piling up of inventories all bode ill for growth. Still, with the surprising figure for the 2^nd quarter, GDP growth for the year is now more likely to fall in the 2.0% to 2.5% range, than below 2%, as previously expected.

Yesterday IBGE published the results for June´s retail sales. Two different indices were published, one incorporating sales of vehicles and construction materials, the other without those items. Month on month, in real terms, and adjusting for seasonality, results for the extended index showed a rise of 1.0%. The less encompassing index, in turn, went up 0.5%. The latter, in particular, came somewhat short of market expectations, which hovered around 0.7%.

Overall, I expected an even worse result, due to the protests that took the streets in June, as malls and stores tended to close during the rallies. Analysts seem to be focusing instead on the decline in sales of supermarket and other food and beverage stores. This, in turn, is being ascribed to higher food prices. Yet, food price inflation actually fell to a modest 0.04% in June, down from an average 1.1% per month in the previous 12 months. Moreover, it is hard to square that explanation with the 1.8% rise in retail sales of food and beverages in May, when their prices went up 0.31%.

Indeed, high volatility makes it hard to interpret monthly statistics, so we should resist the temptation to draw too much from them. It is better, instead, to focus on longer-term trends. Looking at quarterly data, what strikes me is how retail sales have leveled off for the last three quarters. Thus, in the last quarter, seasonally adjusted, retail sales were up just 1.2% against the third quarter of 2012. For the extended index, results were better, but not by much: 1.8%. These compare to 6.7% and 8.2% a year earlier.

Using a simple regression between commerce GDP and retail sales, one may predict the former to mark around 1.4%, year on year, in the second quarter of 2013. This compares favorably to the 0.1% expansion a year earlier, but pales against the annual average of 5.7% in the previous eight years. I expect that commerce GDP will continue to expand at slightly above 1%, year on year, in the second half of the year. For some time at least, it will stop being a driving force pulling output growth up.

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Today IBGE announced July’s consumer price inflation, as measured by the IPCA, the price index used for inflation targeting. No surprises: a low 0.03%, which compares to an average 0.52% per month in the first half of the year. Inflation was also less widespread, with the proportion of prices going up dropping to 58%, from a peak of 73% in February.

Unfortunately, this was insufficient to remove concerns about Brazil’s high inflation. Not only because 12-month inflation is running at 6.3%, but also because July’s low inflation was due to non-recurrent factors: the favorable seasonality, the fall in food prices, and the reversal of the annual rise of public transportation fares, motivated by street protests.

On average, over the last four years inflation in July was 0.25 percentage points below the average for the year. Thus, ceteris paribus, inflation will rise in the rest of the year. The fall in food prices subtracted 0.08 percentage points from inflation in July. Food prices may fall  further, since they are still up 11.4% year on year, but probably not by much. It is even less likely to see a repeat of the deflation in transportation prices, which subtracted 0.13 percentage points from July’s IPCA.

If these three factors were all that counted, it would be reasonable to expect inflation to rise to slightly above 0.40% per month in the rest of 2013. This would bring annual inflation to 5.5% this year, down from 5.8% in 2012. One might then reasonably expect that in 2014-15 the Central Bank could bring inflation closer to the official, albeit half forgotten, target of 4.5% per year. Unfortunately, reality is seldom so linear.

In the next two years, a weaker labor market will help to control inflation. The unemployment rate rose in June and is expected to go further up over the rest of the year and in 2014. Thus, wage rises, which have already been more subdued in the first semester, will probably not keep up with inflation. The minimum wage in 2014 will also increase by less than in recent years, going up between 6.5% and 7.0%.

Lower wage increases will moderate the inflation of non-tradable goods – medical assistance, rent, hairdresser etc. -- which over the last four years averaged 8.0% per year. But this moderation will be gradual, for inflation expectations are unanchored. To bring inflation to the target would require keeping a relatively high unemployment rate for a long time. Market analysts do not believe it. It suffices to say that they project inflation in 2017, four years ahead, at 5.5%, a full percentage point above the target.

A stronger dollar, on the other hand, will play against falling inflation. With the economy cooling down, as expected to happen in the rest of this year, the exchange rate devaluation will impact prices only moderately. But it will impact them, even if slowly. Furthermore, it is likely that the dollar will strengthen further, as the U.S. brings its monetary policy back to normal, reinforcing the pressure on the prices of tradable goods.

Moreover, and more importantly, inflation is being pulled down by unsustainable means. In the past 12 months, prices of transportation rose only 2.2%, less than a third of the mean increase in the remaining prices. In the last four years, the so-called monitored prices – power, gasoline, bus fares etc. -- increased on average just 3.6% per year. This was only possible because the government is spending tens of billions of reals a year in subsidies. These go from transfers to power distributors and bus companies to having Petrobras incur large losses in the sale of gasoline. Eventually, bus and subway fares, as well as gasoline prices, will have to be adjusted for inflation and a weaker real. And this will not entail just a small rise in these prices. It will not happen this year or in 2014, but neither can the government wait much longer than that.

Today IBGE unveiled June’s industrial output statistics. The headline figure – 1.9 percent month on month (MoM) rise, seasonally adjusted (sa) – surprised on the up side. But, coming after a 1.8 percent contraction in May, it only brought output back to April’s level. Overall, though, this year is proving to be a better year for industry than 2012, when its output fell 2.6 percent. In the first semester, industrial output went up 1.9 percent, year on year (YoY), led by a surge in capital goods (13.8 percent) and durable consumer goods (4.9 percent).

The uneven sector performance makes me a bit concerned about the sustainability of this recovery. The expansion in the output of capital goods is closely linked with the surge in the production of trucks: a 48 percent rise in the first semester (YoY). This comes after a 40% contraction in the first half of 2012 (YoY) and is associated with the excellent crop harvested this year, which needs trucks to be transported to Brazil’s ports. In contrast, the output of intermediate goods continues to perform poorly, expanding only 0.4 percent in the first semester YoY, while the output of nondurable consumer goods dropped 0.6 percent.

With most of export crops already harvested, the demand for trucks should cool down. The recent sharp drop in business confidence in industry, construction and services suggests that overall investment is unlikely to perform well in the second half of the year. The outlook is not bright either for consumer goods, given the slowdown in new consumer loans, the weakening labor market and the decline in consumer confidence.

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Next June 25 I will be speaking at the Brazilian American Chamber of Commerce in Miami. It will be an opportunity to discuss the challenges facinf the Brazilian economy as the Presidential elections come close. How will the economy perform until then? What to expect for the post-election period?

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