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Brazil: Inflation Getting Serious

Brazil's inflation rate is becoming a serious problem, experts warn.

Inter-American Dialogue


Brazilian President Dilma Rousseff said [recently] that she is "immensely worried" about inflation in Latin America's largest economy and added that her government will continue working to control rising prices. Her comments came just days after the central bank slowed the pace of its interest rate increases, boosting the Selic rate by 25 basis points. Does Brazil have a serious inflation problem? Is the Brazilian central bank acting aggressively enough? What other measures should the government use to contain rising prices? How is inflation in China, Brazil's largest trading partner, likely to affect Brazil?


Paulo Vieira da Cunha, partner and head of research for emerging markets at Tandem Global Partners: Brazil has a serious inflation problem. Inflation measured 6.3 percent year-on-year in March and the annualized value of the three-month moving average of the seasonally adjusted series, a better indication of trend, measured 8.2 percent. Commodities and food are to blame but inflation is widespread. And note: Petrobrás has not passed on the increase in the price of oil to consumers. This is an 'inflation time-bomb' still waiting to explode. Consider the IPCA inflation index's services component, an aggregate that excludes commodities: The same trend metric used above now measures 13 percent. At last count, the price of 60 to 65 percent of the items in the consumer basket is increasing every month. The ceiling of the inflation target interval (a very generous 6.5 percent year-on-year) will be breached sometime in the next three months. Inflation expectations for 2012 are unanchored. The probability distribution of the central bank survey shows nearly equally probable outcomes in the range of 5 to 6 percent, whereas an anchored response would show an overwhelming concentration of the probability distribution around the 4.5 percent target. Real output is adjusting down but not the nominal demand system fueled by expanding credit, wages and public expenditure; and by adverse inflation expectations that target a 14 percent increase in the minimum wage in 2012. The central bank was slow to react to the problem building up last year. Failures in communication and in the credibility of fiscal promises destabilized expectations that were already compromised by the political calendar, in 2010, and transition, in 2011. A more deliberate pursuit of exchange rate objectives (to circumvent faster appreciation of the real) weakened the anti-inflationary impact of increases in the policy rate. Needing another tool, the central bank unearthed instruments of credit policy long in disuse. They will help. But if history is a guide, policymakers may take too long to help avoid inflationary inertia. The central bank will eventually deliver a higher dose of interest rate hikes, regrettably coinciding with, instead of anticipating, a slowdown in economic activity and employment.


Marcelo Carvalho, head of Latin America economic research at BNP Paribas in São Paulo: Three main themes stand out in the latest minutes of the central bank's Monetary Policy Committee, or Copom. First, the hiking cycle will be more prolonged than first planned (read: the final peak in rates will be higher). Our interpretation is that Copom now recognizes that the total hiking 'budget' will need to be larger-and therefore policy interest rates will peak higher-than the central bank first envisaged. Second, hiking by 25 basis points per meeting is the preferred pace going ahead. Third, the central bank seems to downplay a bit its confidence in the role of macro-prudential measures as a policy tool, which in turn underscores the role of conventional policies including rate hikes. In sum, rates will peak higher than first planned, but we will get there at a slower pace. The local yield curve will likely price in a series of additional 25 basis-point hikes from here. The recent minutes still sound dovish compared with the harsh reality of a very worrisome inflationary picture. We have been systematically more cautious on inflation than both the central bank and the market consensus. Our above-consensus 2011 inflation forecast is at the extreme tail-end of the distribution of individual market forecasts, according to the central bank's comprehensive survey. We think inflation is a much bigger challenge than the authorities seem willing to admit. A hesitant policy tightening will do little to re-anchor inflation expectations. The common view is that growth will remain strong, at about 4.0-5.0 percent this year and next, at the same time that inflation will nicely converge to the target center of 4.5 percent by 2012. We disagree. Something has to give. Either the economy will have to cool substantially below potential, or inflation will prove a nastier problem. Our out-of-consensus forecast sees inflation finishing 2011 above the target tolerance ceiling, forcing the authorities to tighten more than they seem to have hoped for, and entailing a more pronounced growth slowdown next year. In sum, bringing inflation back to target will likely prove a long and winding road.


Tony Volpon, head of emerging market research for the Americas at Nomura Securities International Inc.: Brazil's inflation problem has two root causes; First, the excess demand created by the expansionary fiscal, credit and wage policies which were instituted during the 2009 financial crisis but maintained during the 2010 election cycle. This has led to a steady fall in the unemployment rate and thus to higher prices for nontradable, domestically produced goods. Services inflation in Brazil is currently running at 8.4 percent per year, against its 4.5 percent inflation target. To this has been added imported inflation due mostly to higher commodity prices since the announcement of QE2 last year. Inflation of tradable, imported goods is running at 6.1 percent per year. The government of Dilma Rousseff has decided to take a gradualist and multipronged approach to solving the inflation problem, while trying to minimize the damage to growth and stop further appreciation of the exchange rate. The emphasis has been on fiscal adjustment and macroprudential policies targeted at controlling credit growth. Unfortunately, so far the measures taken have not had any effect on current inflation, which continues to be higher than expected, or in bringing inflation expectations to target (current expectations for inflation over 12 months is at 5.4 percent). The latest decision by the Central Bank of Brazil to slow down the pace of adjustment of the policy rate from 50 basis points to 25 basis points reinforced the gradualist strategy even as it promised to raise rates for as long as necessary. Nonetheless, the market is still skeptical that the government will, if necessary, chose inflation stability against lower economic growth.

Markus Jaeger, director at Deutsche Bank Research in
New York: Brazil is facing an inflation challenge and if the central bank fails to take more aggressive action soon, this challenge could mutate into an inflation problem. The inflation target is 4.5 percent, plus or minus two percentage points. According to the latest market survey, year-end inflation expectations have risen to 6.3 percent and, more importantly, year-end 2012 expectations have crept up to 5 percent. This un-anchoring of inflation expectations has taken place despite a downward revision of economic growth. Granted, raising interest rates aggressively to contain inflation against the backdrop of strong capital inflows and a strongly appreciated currency puts the central bank, economically and politically, in an unenviable position. If the central bank fails to rein in inflation (expectations), however, it will risk an erosion of its hard-won credibility and its ability to anchor and guide expectations and economic agents' pricing behavior. This will eventually force the bank into an even more aggressive monetary tightening. The central bank should have stayed 'ahead of the curve' by hiking interest rates earlier and more aggressively than it has done thus far. Markets also remain skeptical as to the effectiveness of macro-prudential measures as a substitute for interest rate hikes. Even if such measures turn out to be effective (at the margin), it is impossible to predict the degree to which they will be effective, compared to conventional rate hikes. This has further contributed to monetary uncertainty and the un-anchoring of inflation expectations. 

Republished with permission from the Inter-American Dialogue's daily Latin America Advisor newsletter. 

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