Already Lofty Interest Rates in Brazil Get Even Higher

Brazil’s central bank on Wednesday pushed one of the world’s highest real interest rates even higher, tightening monetary policy for the second time in three months in a bid to slow accelerating inflation.

The central bank raised the benchmark lending rate by a half percentage-point to 11.75% per year.

The rate increase underscores a complex policy conundrum facing the two-month-old government of President Dilma Rousseff. Higher interest rates are needed to roll back inflation—long the emerging nation’s Achilles’ heel. At the same time higher interest rates can have unwanted side effects, such as stifling growth.

The high interest rates have attracted a flood of foreign investment that’s pushing up the value of the Brazilian real against the U.S. dollar, making Brazilian manufacturers and exporters less competitive in global markets. In recent weeks, the Rousseff administration has announced $30 billion spending cuts that officials hope will take pressure off rates and inflation. But even those are difficult: Brazil is depending on an enormous amount of government investment to build new ports, roads and power generators to unleash future growth.

And that’s not to mention all the stadiums and airport upgrades it will need before hosting the 2014 World Cup and the 2016 Olympic Games.

Some analysts had suggested the bank was considering even a bigger increase. But the unanimous move by the seven central bank directors suggests the central bank is taking a cautious approach. Some economists have argued that the inflation pressures will recede in the near-term, while others have argued for a more aggressive 0.75 percentage point increase to clamp down on rising inflation expectations.

Still, economists are expecting more interest-rate increases, and see the rate standing at 12.50% by the end of this year. The central bank’s next interest rate announcement is scheduled for April. 20.

In Brazil, the underlying pressure on prices started with a surge in global food prices in the latter half of 2010, but economists now fear that this has spread to other parts of the domestic economy, amid strong growth, low unemployment and rising salaries. Inflation data from early February indicated that, although food prices had started to come off the boil, the pressure on inflation remained constant.

“Rapidly increasing commodity prices weigh on an overheated economy” and “service inflation is also a major source of pressure,” said economists at Itau BBA, in a research report published before the decision.

Consumer price inflation, as measured by the IPCA index, nudged up close to 6.1% on a 12-month basis through mid-February, and economists see the rate slipping slightly to 5.80% by year-end, but that’s still well above the government’s goal of 4.5%. Markets see the Selic rate ending the year at 12.50%.

Just as in other emerging market countries, including China, Brazil has deployed a series of measures, from budget cuts to reining in bank loans, as it seeks to battle inflation, but for the most part the central bank directors appear to favor waiting for further evidence of the impact.

For one thing, some recent data suggest that the economy might be slightly softer than had been expected, and that aggressive rate hikes may not be needed, although industrial production data published earlier Wednesday came in slightly stronger. Fourth-quarter gross domestic product growth is scheduled to be published on Thursday.

At the same time, the government is reluctant to raise rates as that could exacerbate the flow of money into Brazil, attracted by the high borrowing rates, especially compared with the developed world, where rates are close to zero.

Moreover, the central bank will be keen to avoid raising rates any more than is absolutely necessary. The sky-high levels have attracted considerable amounts of investment into Brazil, which have contributed to the strong appreciation of the Brazilian real.

“Accelerating the pace to a 75-basis-point hike would be highly problematic for the exchange rate, as the real may accelerate its strengthening trend,” noted Banco Santander economist Alexandre Schwartsman in a note earlier Wednesday. Brazil’s currency, the real has appreciated by more 30% against the dollar over the past two years under the impact of heavy foreign exchange inflows.

Still, economists are expecting more interest rate hikes, and see the Selic rate standing at 12.50% by the end of this year. The central bank’s next interest rate announcement is scheduled for April. 20.