Central Bank of Brazil Softens Pace of Rate Hikes

Brazilian Central Bank Increases Targeted Benchmark Selic Rate

The Central Bank of Brazil is tightening monetary policy, taking measures to reduce liquidity and also to cool down demand. At its latest Monetary Policy Committee (COPOM) meeting on 20 April—the third under the new administration, which took office in January 2011—the central bank raised the policy rate by 25 basis points to 12.0%. In each of the previous two meetings the rate had been increased by 50 basis points.

In April 2010, the central bank had begun a tightening cycle after witnessing signs of higher inflation. However, these vanished in the third quarter of 2010, prompting the monetary authority to pause its rate increases. As high inflation returned in October 2010, the bank resumed the tightening cycle in January 2011. Higher rates are intended to discourage consumption and investment and thus reduce aggregate demand.

Other Brakes Applied

In December 2010 the central bank decided to raise reserve requirements on time and demand deposits in order to curb credit growth and prevent the formation of asset price bubbles. The Brazilian economy emerged very rapidly and strongly from the 2009 global recession, to the extent that the central bank had to increase rates to put the brakes on the economy in order to avoid overheating. This is a situation whereby rapid economic growth increases demand and the productive sector cannot respond by raising output, leading to excess demand translating into upward pressure on prices. In April–July 2010, the bank lifted rates from 8.75% to 10.75% and price stability returned. Although inflation was clearly driven by higher prices in the food and beverages category in early 2010, the bank had to act because there were signs that the economy was growing too rapidly. In addition, inflation was contained by controlling the growth of so-called supervised prices—among them the prices of gasoline (petrol), alcohol, and gas, tariffs on utilities, and transport fares. The price stability lasted for only three months from June to August. From September 2010, food prices started to surge again, while supervised prices lagged behind the overall consumer price index.

Under Meirelles, Central Bank Had Shown Commitment to Price Stability

For many years now, the Central Bank of Brazil has shown its commitment to price stability and to inflation targeting. The inflation target is relatively soft at 4.5%, plus or minus 2 percentage points, but the central bank has complied with it even during the worst of the commodity price shock in mid-2008. In early 2010, under the previous administration and the presidency of Henrique Meirelles, the central bank wanted to send a strong signal with its first three policy-tightening moves, and the combined 200-basis-point increase in the policy rate was a clear message that the bank would not tolerate high inflation. The central bank had already taken other measures to restrict liquidity, such as increasing the reserve requirement on bank deposits.

Economy Is Overheating

The government has also announced cuts in fiscal spending. Both fiscal and monetary policy measures are based on the assessment that rapid growth in demand may not be matched by increases in supply, thus resulting in the overheating of the economy and higher prices. Capacity utilisation in Brazilian industry does not provide conclusive evidence of an overheating economy, although it is clear that the level of idle capacity has declined considerably in recent months. The next COPOM meeting is on 7–8 June.

Outlook and Implications

Increasing rates more aggressively would help to tame faster inflationary expectations—and probably inflation, which should be the priority of the central bank. Higher rates aimed at discouraging consumption and investment and thus domestic demand would not only damage GDP growth but would also attract more short-term capital inflows that would place downward pressure on the exchange rate (Brazilian reais per United States dollars) and further exacerbate the appreciation of the local currency. This is already hurting the competitiveness of some Brazilian exports and the cheap exchange rate also implies a lower cost of imports that compete with local producers on the domestic markets.

In its brief communiqué, the central bank mentions the uncertainty regarding economic deceleration as a key element in the lower-than-expected increase in the targeted rate (it should not and does not mention the exchange rate issue). In IHS Global Insight's view, the priority of the monetary authority must be price stability and not economic growth or employment. Although inflation is in part being driven by supply shocks such as higher oil and food prices, there is evidence that excess demand is also part of the story: core inflation, which excludes most food and energy items, amounts to 5.7%, a clear sign that there has been contagion among other prices and that inflation is now a generalised problem. An argument in favour of the central bank's slower but longer-term approach to interest-rate hikes is that the policy rate is already high and should already be having the desired tightening effect on aggregate demand. But since domestic credit continues to grow, sponsored by the government through the National Development Bank (BNDES) and to a lesser extent the other two big state-owned banks (Banco do Brasil and Caixa Federal), the monetary authority is cautious about the overall effect higher rates may have on the economy. It is clear that the central bank has fears about the deceleration of the economy, but in our view it is putting too much weight on this risk and too little emphasis on the risk of inflation.