Brazil: Something’s got to give

February 7, 2013

How about living in a fast-growing economy with tame inflation, record-low interest rates, stable exchange rate and shrinking public debt. Sounds like paradise, doesn’t it? But Brazil may be starting to realize that this is also impossible.

Inflation hit the highest monthly reading in nearly eight years in January, rising 0.86 percent from December. It also came close to the top-end of the official target, accelerating to a rise of 6.15 percent in the 12 months through January.

That conflicts with key pillars of Brazil’s want-it-all economic policy. The central bank cut interest rates ten straight times through October 2012 to a record-low of 7.25 percent, saying Brazil no longer needed one of the world’s highest borrowing costs. The government also forced a currency depreciation of around 20 percent last year, aiming at boosting exports and stopping a flurry of cheap imports.

The central bank still bets that inflation will subside in the second half of this year. But with a tight labor market and core inflation measures rising steadily, it’s not clear that this will take place and even if 2014 inflation – with the effect of recent electricity rate cuts fading – wouldn’t continue to seem ugly. Something has got to give. Either Brazil accepts higher inflation, or it allows its currency to flow more freely and/or raise interest rates, as futures markets expect.

“The central bank will tolerate a stronger real in an effort to limit imported inflation, but this will come at the expense of a further deterioration in Brazil’s external competitiveness, which will weigh on economic growth”, said Capital Economics’ chief emerging markets economist Neil Shearing.

Finding itself in a policy trap, it may be even harder for the government to boost the economy. But perhaps tame inflation – and reliable prospects – would do more good for business investments than low interest rates.

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