Brazil’s inflation problem

January 16, 2013

When will Brazil’s central bank admit it has an inflation problem? Markets will be watching today’s rate-setting meeting for clues.

There is no doubt about the outcome of today’s meeting at the Banco Central do Brasil (BCB) — no one expects it to do anything but leave interest rates steady at the current 7.25 percent. But the BCB has been focused on growth for 18 months and has cut interest rates by 525 basis points in this time, its actions helping to drive the real 10 percent lower last year versus the dollar. The government meanwhile has unleashed huge doses of fiscal stimulus. The result, rather than a growth recovery, is a steady rise in inflation.

Goldman Sachs’ Latin America economist Alberto Ramos points out that Brazilian inflation came in above the 4.5 percent target for the third straight year in 2012 and the balance of inflation risks has deteriorated. Gasoline prices are to rise from next week and drought is making hydro-power generation more costly. Analysts polled by Reuters expect 2013 price growth at 5.53 percent. Ramos writes:

We are of the view that at a certain point the central bank needs to own the inflation problem and acknowledge that just remaining on automatic pilot may not be enough to drive inflation to the 4.5% target by year-end 2013.  

The bank will not raise interest rates any time soon and is sticking to a 4.8 percent inflation forecast for 2013 . Ramos says the bank must at least change its post-meeting message in which it has referred to “a stable/unchanged monetary stance for a prolonged period of time”.

That would serve the monetary authority well to bolster credibility as an inflation targetter and would still not necessarily commit the central bank into having to deliver Selic rate hikes in 2013.

What of markets? Brazilian interest rate futures are  implying a quarter point rate hike within the next 6 months and 60 bps of rate hikes over the coming year.  Given the central bank’s dogged focus on growth, that sounds too hawkish. Analysts at TD Securities reckon that instead of an orthodox rate hike, Brazil may  deploy some macroprudential measures to tighten policy via absorbing excess liquidity in the banking system. The BCB may also try the exchange rate mechanism. TD analysts note that the real has already gained some ground in recent weeks and is now ranging between 2.02 and 2.05.

Brazil is not alone of course. The growth versus inflation conundrum has been dogging central banks around the world, with even some Fed officials recently voicing concern about the consequences of unlimited money printing. The argument continues.

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