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Thursday, June 5, 2008

Brazil Central Bank Raises Interest Rates to 12.25%

by Edward Hugh: Barcelona

Brazilian central bank President Henrique Meirelles and the other seven members of the central bank board raised the benchmark lending rate a half percentage point yesterday to curb accelerating inflation fueled by higher food costs and record consumer demand. The central bank increased rates to 12.25 percent from 11.75 percent.

"Continuing the adjustment process of the benchmark interest rate, which was initiated at the April meeting, the Copom decided unanimously to raise the Selic rate to 12.25 percent a year without bias" the bank said in a statement.

Henrique Meirelles also indicated policy makers are very likely to raise the benchmark lending rate further to contain inflation. The bank removed language from its April 16 statement saying it had carried out a ``significant part'' of the tightening process and in that sense the `rocess is much more ``open-ended.'' and the tightening cycle may well be longer than the previous statement indicated. The central bank are effectively going to increase the rate as much as they feel is needed.

Meirelles told the Brazilian parliament at the end of May that the bank will act to prevent rising wholesale industrial and agricultural costs from spreading to consumers as household demand expands at a record pace. The IGP-M inflation index, which has a 60 percent weighting in wholesale prices, rose to a three-year high of 11.53 percent in May.

Consumer prices had their biggest increase in four months in April on the back of of higher food costs. Consumer prices, as measured by the government's benchmark IPCA index, climbed 0.55 percent In April - up from 0.48 percent in March. Brazil's inflation rate in the 12 months to April was 5.04 percent.

Most of the macro economic indicators are showing signs of strong demand. Lending by banks has climbed at least 20 percent in each of the past three years. Retail sales jumped 11.4 percent in March, capping the strongest quarter on record. Industrial production jumped 10.1 percent in April from a year earlier, the highest in six months.

This picture is only completed when you think about the large inflows of funds Brazil is receiving at the present time. Brazil received $37.2 billion of foreign direct investment in the 12 months through April, a record annual inflow, and foreign exchange reserves were up to $195 billion in March 2008.

The half-point rate increase pushes Brazil's real interest rate, which is the rate after adjusting for inflation, to 7 percent, the highest among the world's leading economies.

Meirelles is also receiving significant backing from Brazil's President Luiz Inacio Lula da Silva who, after being re-elected to a second term in 2006, vowed to accelerate growth to a 5 percent annual pace through 2010. Economic growth accelerated last year to 5.4 percent and Brazil's economy grew at a 6.2 percent rate in the fourth quarter, more than twice the average pace of the past decade.

The principal problem facing monetary policy is that as interest rates rise external funds are attracted by the yield differential which can be obtained and this only adds to internal inflationary pressure.

The only real tools left to the government are institutional reforms to increase capacity and fiscal surpluses to drain some of the excess internal demand. Allowing the currency to rise further can also help, but again there is a delicate balance to be struck here between soaking up imported inflation and creating structural distortions in the development of the economy such that industrial growth is curtailed by problems created for manufactured exports by a strong currency and the excessive growth of financial services and construction fuelled by the availability of cheap borrowing (made possible by the achievement of investment grade) and the consequent acceleration of internal demand. Obviously we have just seen some of the difficulties presented by the end point to which this process can lead in the case of the US and we are currently witnessing an extreme case scenario in the case of Spain's current slowdown. Brazil needs to try to learn some lessons from what we have just seen. Attracting cheap finance on the back of "investment grade" securities is excellent if the underlying assets are "reasonably priced" - this is the hard part.

There is a real Scylla and Charybdis to be steered here between being export driven and excessive dependence on domestic demand, and I don't think anyone has found the "best path" here yet, but we do need to realise - as my colleague Claus Vistesen keeps emphasising (and see here for the Japanese case) - that someone needs to soak up the world's growing surpluses somewhere, and Brazil certainly seems to be one of the stronger candidates in the short term.

Brazil's politicians do seem to be on a learning curve here, and Finance Minister Guido Mantega, who only last February was questioning the need for more rate increases, this month reversed course and decided to cut the fiscal deficit at a faster pace to help rein in inflation. Yielding to calls by Meirelles, Mantega announced last week the government would cut spending by an additional 13 billion reais this year, boosting the budget surplus before interest payments to 4.3 percent of gross domestic product from 3.8 percent.