Emerging Markets Eye Brazil's Rate Cut Gamble

14 September, 2011

For Alexandre Tombini, the president of Brazil’s central bank, last week was one of the more tumultuous in his nine months in the job.

Mr Tombini was forced to clarify on television a surprise decision to cut interest rates even as consumer prices hit a six-year high amid concern among private sector economists that the central bank was watering down Brazil’s cherished inflation-targeting regime.

“The central bank continues to operate with autonomy,” Mr Tombini told Globo TV, rejecting claims that the interest rate cut was a political decision.

Brazil’s about-turn on interest rates, in which it abruptly ended its tightening cycle this year by slashing 50 basis points off its benchmark Selic rate to reduce it to 12 per cent, is a gamble that is being watched by emerging-market policymakers around the world.

Latin America’s biggest economy is not the first to cut interest rates citing the weakening global outlook – Turkey began easing in early August.

But Brazil is the largest emerging-market economy so far to have begun easing. And, given the country’s chequered history with inflation, which in past decades was a destabilising force in the economy, the issue is highly sensitive.

The central bank’s call to begin easing now was all the more significant because inflation in the 12 months to the end of August reached 7.23 per cent – the highest since 2005 and well beyond the official target of 4.5 per cent plus or minus 2 percentage points.

In the minutes of the monetary policy meeting that decided on the rate cut, which were released last week, the central bank said it believed that the global economy was facing a shallower but longer period of weakness than in 2008-09. In this environment, the central bank could cut rates and still meet its inflation target next year of 4.5 per cent.

“Since the last meeting of the monetary policy committee, the outlook for the global economy has deteriorated,” the minutes said.

The sudden about-face by the bank, which until then had been increasing interest rates this year, adding 175 basis points to the benchmark rate, prompted concern among market economists that the central bank was taking a gamble on inflation for political reasons.

“There is some dissonance, some tension there between their actions and their rhetorical commitments to the inflation target,” says Alberto Ramos, an economist with Goldman Sachs. “If they were really committed … [to] getting inflation to the target by 2012, I think in the name of prudence they probably should have held rather than cut.”

The government of President Dilma Rousseff is keen to see lower real interest rates – Brazil’s are the highest in the world for a large economy.

Lower interest rates would also ensure economic growth continued at a reasonable pace after last year’s rip-roaring 7.5 per cent. Easier monetary policy might also weaken Brazil’s currency, the real, against the dollar, which the government blames for undermining domestic industry.

At the heart of economists’ concerns is whether the central bank’s autonomy is in jeopardy. “We believe the Brazilian authorities are operating a new policy regime with three targets – growth, inflation and [the exchange rate],” wrote Nomura economist Tony Volpon in a report. “The risk of surprising, ‘stop-and-go’ changes in policy priorities … and greater interference in markets is, we believe, a new permanent part of the economic and market landscape.”

Economists dispute that there is clear evidence that external conditions are so negative that inflation will die off in Brazil. If the US embarks on more quantitative easing, commodity prices could stay high, favouring the Brazilian economy. China’s economy, the mainstay of Brazil’s commodity exporters, also remains buoyant.

Most economists have lowered their forecast for Brazilian economic growth to between 3 and 4 per cent but these levels might be high enough to sustain inflation above the official target, given a tight labour market and expected wage increases.

Goldman Sachs’ Mr Ramos argues that even if the central bank proves correct and the global outlook deteriorates so much that inflation does converge to the target next year, its methodology is questionable.

“In the end it might turn out OK for Brazil, it might turn out to have been the right decision, but that does mean the process was right because there is an element of a gamble, of wishful thinking in this decision,” he said.

In his TV interview, however, Mr Tombini said the world had changed between the last two meetings of the monetary policy committee. And he rejected claims that the central bank was now serving more than one master.

“The central bank does not have any other target than inflation,” Mr Tombini said.

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Emerging Markets Eye Brazil's Rate Cut Gamble

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