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.
Traumatized by several currency crises in the past, Brazil has made a dedicated effort in recent years to amass $374 billion in foreign reserves as China bought mountains of its iron ore and soybeans. When the next crisis came, policymakers figured, the reserves would act as Brazil’s first line of defense.
Brazilian economic policy is fast becoming a shining example of the law of unintended consequences. As activity fades and inflation picks up, the government has tried several different measures to fix the economy – and almost every time, it ended up creating surprise side-effects that made matters worse. Controls on gasoline prices tamed inflation, but opened a hole in the trade balance. Efforts to reduce electricity fares ended up curbing, not boosting, investment plans.
In times of currency wars, it’s best not to shoot yourself in the foot. By imposing several capital controls in the past years, Brazil might have tightened monetary policy right when the economy started to falter, Nomura’s strategist Tony Volpon wrote in a research note on Friday.
Tiago Pariz in Brasilia also contributed to this post.
Brazil’s Trade Minister Fernando Pimentel was the latest authority this week to fire warning shots in a resurging currency war. The government is “focused” on keeping the real at its current level of 2 per U.S. dollar, he told journalists after a meeting with fellow ministers and businessmen.
Ironically, an increase of capital inflows to Latin America in the last few years due to unappealing ultralow yields in industrialized countries and the region’s relative economic success is posing a threat for development, according to a recent paper that provides wider background to BRIC criticism of the latest U.S. Federal Reserve´s quantitative easing.