Brazil’s central bank showing no mercy on rates

April 30, 2015

Man tries walks between two trunks towards the cracked ground of the Atibainha dam as it dries up due to a prolonged drought in Nazare Paulista

At 13.25 percent, Brazil’s towering interest rate looks totally out of line at first glance.

The economy is slipping into its worst recession in 25 years; falling prices are spooking central banks around the globe; rates in Latin American peer economies are much lower, below 5 percent.

Nearly every other central bank, from Japan and Australia to emerging market rivals China and India, have eased policy since the start of the year. Even Russia, a hot spot for currency crises, is going the opposite way, slashing its benchmark rate to 12.5 percent on Thursday from 14 percent previously.

Some forecasters are even saying the Federal Reserve and the Bank of England, not long ago touted by most to be leading the world with policy tightening this year, now won’t raise rates until 2016.

Still, most observers in Brazil and abroad are stepping short of calling the central bank’s strategy overkill. Several are predicting yet another hike this year as Brazil’s long battle with high inflation continues.

It is all about trying to re-establish credibility. But many economists are failing to highlight how risky it is for a central bank to be trying to build credibility by hiking rates when the rest of the world is headed in the opposite direction.

Indeed, economists calling for rate hikes are the same ones who lambasted the central bank for slashing interest rates to record lows in 2012, even when inflation was above the official target. The bank’s strategy failed, heightening Brazil’s chronic imbalance between strong demand and insufficient supply.

The outcome, as they predicted, was even higher inflation along with lower business and consumer confidence – and thus weaker overall economic growth.

After that episode, markets became convinced Brazilian policymakers would tolerate high inflation. So when the central bank changed tack and returned to a textbook inflation-targeting strategy, there really was only way to win back its reputation: show no mercy.

“This tightening cycle runs contrary to global trends and weak domestic growth but reflects a necessary shift to prioritize the inflationary risks and restore the commitment to low inflation,” said Siobhan Morden, head of Latin America strategy at Jefferies.

Measures of inflation expectations signal price rises will ease sharply next year to about 5 percent from over 8 percent this year. Still, that is above the bank’s 4.5 percent target, and leaves the door open for further rate hikes in coming months. BNP Paribas, for example, expects rates to stop rising only at 14 percent.

See how that compares with other Latin American countries (Brazil in yellow, Chile in red, Mexico in purple, Peru in blue and Colombia in green):

benchmark

Most say this is a temporary peak. A Reuters poll on Wednesday showed economists expect rates to start falling in early 2016 as inflation subsides. But they also thought the pace of declines would be slow, keeping the Selic rate in double digits for a very long time.

The real risk is that the bank’s drive to prove itself will send Brazil into a prolonged crisis, torpedoing the government’s own efforts to improve its finances and putting the country’s investment grade at risk.

Unemployment has risen to a three-year high, mortgage lending has dropped for the first time after a decade-long boom, and business and consumer confidence remain extremely depressed.

As the central bank itself says, monetary policy actions have lagging and cumulative effects. If the economy plunges, it may be too late to react.

With reporting by Deepti Govind

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