Analysis: against inflation, Brazil heading for monetary overkill?

A chronically weak currency and renewed concern over the public finances are only redoubling the Brazilian Central Bank's commitment to raising rates

Analysis: against inflation, Brazil heading for monetary overkill?
Photo: REUTERS/Adriano Machado/File Photo
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Brazil‘s central bank has put itself on the front line of the global battle against inflation, but its aggressive monetary tightening risks choking the economy.

With annual inflation at 10%, the central bank will fail to meet its 3.75% central target this year and possibly next year’s 3.50% goal too. A chronically weak currency and renewed concern over the public finances are only redoubling its commitment to raising rates.

In many ways, it has little choice.

Unlike the U.S. Fed or European Central Bank which have blurred their inflation-targeting guidelines recently to give themselves greater policy flexibility, the Brazilian central bank’s framework is more rigid.

READ ALSO: Market forecasts higher inflation and devaluation of the Brazilian real against the dollar this year

It has a year-end target, with a 1.5 percentage point margin of error on either side, which does provide some leeway. But it is effectively beholden to a point forecast, and given Brazil‘s hyper-inflationary past, policymakers are loathed to risk their credibility by missing it.

This is why the bank’s rate-setting committee known as “Copom” will deliver its fifth consecutive rate hike on Sept. 22. The only question is whether the benchmark Selic rate will be raised by 100 basis points, as it was in August, or more.

But it is a blunt tool, and the economic outlook is darkening.

By some measures, real interest rates are not deeply negative, as the running assumption goes, but are actually among the highest among all major economies.

READ ALSO: Brazil and Mexico: how cenbank of the two largest Latam’ economies face rising inflation

Robin Brooks at the International Institute of Finance in Washington calculates that, based on 10-year nominal government bond yields and 10-year breakeven inflation rates, Brazil‘s real interest rate is just under 5%.

That is the highest across a range of key developed and emerging economies.

Brooks says using longer-term inflation measures strips out the current supply bottleneck issues and “noise” in recent inflation readings, giving a fairer picture.

Jason Vieira at Infinity Asset Management in Sao Paulo uses a shorter-term outlook but arrives at a similar conclusion. Based on the difference between the most liquid 12-month interest rate futures and projected inflation over the next year, he calculates that real rates in Brazil are around 2.5%.

That might not sound a lot, but according to his analysis of 40 major developed and emerging economies, it is the second-highest in the world behind Turkey. And he sees it rising above 4% next year.

Lost decade

Recent swings in Brazil‘s inflation, currency and interest rates have been remarkable.

Copom is now commanding one of the most aggressive rate-hiking cycles of any G20 central bank, and inflation is the third-highest of any G20 country behind Argentina and Turkey.

Yet in May last year inflation was the lowest in Brazil‘s recorded history, below 2%, and as recently as March this year the Selic was at its lowest ever level of 2.00%. The current Selic rate is 5.25% and its terminal rate could be closer to 10%.

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Former central bank chief Arminio Fraga shares the orthodox view that the central bank has no option but to raise rates in order to anchor credibility on inflation, support the currency, and counter a deteriorating fiscal outlook.

“We are not at a situation that is fully under control yet,” he told Reuters earlier this month.

But he also acknowledged that growth has for a long time been “really mediocre.” Periods of growth are usually “low and highly volatile,” and go beyond the pandemic and short-term economic cycles.

According to the central bank’s latest weekly “FOCUS” survey of over 100 economists, Brazil is on course to grow by 5% this year. That is a solid “V-shaped” recovery from last year’s 4.1% contraction, as Economy Minister Paulo Guedes often points out.

Yet the median “FOCUS” forecast for next year has slumped to 1.6% GDP growth from 2% three weeks ago. In March it was 2.5%.

Brazil‘s economy is more than halfway toward a lost decade. It is 3% smaller than its peak in early 2014, and since then it has suffered two deep recessions and failed to grow more than 2% in 2017, 2018 or 2019.

READ ALSO: Bolsonaro raises financial tax to fund cash transfer program that could replace Bolsa Família

Unemployment has remained chronically high. It has been over 14% for most of the past year, and the last time it was below 10% was almost six years ago.

Underlying numbers also show that if the labor force participation rate was at pre-crisis levels unemployment would be over 20%. More than 30 million people, almost a third of the active labor force, are underemployed.

Significantly higher interest rates are unlikely to narrow that slack or strengthen Brazil‘s near-term growth dynamics.

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