Brazil’s shock therapy against inflation

March 3, 2015

Brazil's Central Bank President Alexandre Tombini reacts during the first ministerial meeting in Brasilia

Brazil’s central bank’s two-day policy meeting kicks off later on Tuesday with all bets placed on a fourth straight interest rate increase, despite growing consensus that the country is headed for its worst economic recession in 25 years.

The benchmark interest rate, currently at an already-high 12.25 percent, is expected by the wide majority of 48 economists polled by Reuters to reach the highest in six years at 12.75 percent. Other increases are in the pipeline, and some say the Selic rate could climb to as much as 13.75 percent this year.

Monetary tightening is just one side of Brazil’s all-out war on price rises.

Finance Minister Joaquim Levy, tasked by President Dilma Rousseff to plug a growing budget deficit, has already frozen dozens of billions of dollars in government spending, removing one of the major pressures over consumer prices in recent years.

Taken together, these are by far the most aggressive initiatives against inflation in Brazil in over a decade, right at a time when consumer prices are easing across the globe because of lower commodity prices. Unemployment is already on the rise, and economic growth is set to drop 0.6 percent this year, the steepest fall since 1990.

It is striking, then, to notice that inflation expectations have barely fallen so far. Median market forecasts for inflation over the next 12 months have hovered around 6.5 percent over the past three months, according to a weekly central bank survey. The same poll shows inflation is set to remain above the 4.5 percent target through 2019.

12-month inflation expectations:

Source: Central bank

These same market economists have underestimated inflation for years, which raises the question of whether they are not erring on the other side this time. If Brazil’s inflation superbug survives such strong medicines, something ought to be very wrong with its economy – or with economic textbooks.

How much pain can Brazil stand? Which will give up first, inflation expectations or policymakers, fretting with a stumbling economy?

For now, economists ask for patience. Widespread pessimism may have even created some opportunities for savvy traders.

Siobhan Morden, head of Latin America strategy at Jefferies LLC, wrote:

It may be a slow process to restore its inflation fighting credentials; however so much bad news is priced in that the risk/reward favors scaling into long relative value positions.  Brazil 10Y USD credit spreads are trading at historic worst levels on decoupling from investment grade peers while also trading cheaper than BB credits.

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