Brazil’s currency tests central bank’s patience

October 5, 2015

Brazil's Central Bank President Tombini gestures during a public hearing of the Budget Joint Commission in the Chamber of Deputies in Brasilia

The Brazilian real’s dramatic drop has left the central bank with two options: jack up rates aggressively in one startling move, or tolerate higher inflation for longer.

Inflation expectations continued to rise last week as the Brazilian real plunged to a record low, central bank data showed earlier on Monday. The weaker exchange rate has driven up fuel and food prices, leading the inflation rate towards 10 percent this year – a remarkable feat for an economy headed to its longest and perhaps deepest recession since the 1930s.

As the charts below show, inflation expectations are not only higher but more dispersed too. Uncertainty over Brazil’s political and budgetary crisis has clouded economic forecasting and weighed on business decisions.

2015

2015

2016

2016

2017

2017

2018

2018

As inflation climbs higher, traders have started to bet the central bank will have to raise interest rates from an already-high 14.25 percent. Even after some recent respite following a cabinet reshuffle by President Dilma Rousseff, rate futures are still pricing in more than 150 basis points of rate increases through the next 12 months. Some economists have suggested the bank could emulate Russia’s or Turkey’s recent past and go for a hefty, one-off rate hike to kill inflation pressures from the start.

A majority of economists, however, thinks this is a very bad idea. They have good reasons to believe so.

First, higher rates would wreak more havoc on an economy already in a deep recession.

Second, borrowing costs would become too expensive for Brazil, already running a budget deficit of 9 – yes, nine – percent of GDP, and growing.

And third: what Brazil needs now, in the middle of a confidence crisis, is more, not less, transparency. Hiking rates abruptly and aggressively could add even more uncertainty to an economy already in a tailspin. The economy is contracting, the output gap is opening; inflation will fall. Pursuing an arbitrary goal to lower it by end-2016, instead of mid-2017, could do more harm than good, most economists say.

“Although we don’t discard the chance of a rate hike, the price action looked more to be panic-driven than anything else,” BBH strategists, led by Marc Chandler, wrote in a note. “We still think there may be some risk premium to be taken out, especially if the real remains under control.”

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