Brazil Rates Are Focus as Inflation Edges Higher

This week’s expected increase in Brazil’s already towering interest rates highlights inflation concerns in Latin America’s biggest economy and the difficulty President Dilma Rousseff faces in trying to reduce rates to levels more in line with those of developed markets.

Shortly after her election in October, Ms. Rousseff said she saw no reason why Brazilian rates, the highest of any major economy, couldn’t “converge” with rates in the developed world.

But creeping inflation, fueled by a fast-growing economy and huge increases in government spending in recent years, leaves Brazil’s central bank with little choice but to keep pushing rates higher, economists say.

Analysts expect policy makers, after a two-day meeting ending Wednesday, to push the benchmark rate to 11.25%, up from the current 10.75%.

Further rate increases could follow as the central bank, which enjoys de facto autonomy from the administration, gauges inflationary pressure later in the year.

The dilemma for Ms. Rousseff hinges on what economists, investors, and the local business community have long criticized as a handicap in Brazil’s economic-policy mix.

By relying too heavily on the central bank to control inflation—through interest rates and other measures to stem private spending—Brazil’s government gives itself an excuse to spend more than it otherwise could.

“There must be a shift away from relying so much on monetary policy,” said Neil Shearing, an economist at London-based Capital Economics, a research firm. “At some point, there needs to be a move toward fiscal discipline.”

Ms. Rousseff, who took office on Jan. 1, in recent weeks said her government will take steps to slow spending. Her administration, however, has yet to say how or by how much.

Spending by the federal government more than doubled in Brazil over the eight-year administration of Luiz Inácio Lula da Silva, Ms. Rousseff’s predecessor and mentor, reaching almost 20% of the overall economy.

Although the spending helped Brazil weather the global downturn, as public outlays spurred private economic activity, the government continued the increases even after the country had resumed growth.

The government was particularly criticized by economists for high spending in 2010, an election year.

Now, reining in spending is considered vital to slow an economy that is expected to have grown nearly 8% last year.

Big price increases came with the growth, especially for food, energy, and other staples. Inflation by year’s end reached almost 6%—well beyond the government target of 4.5%.

While rate increases are a proven way to cool inflation, some policy makers argue that spending cuts would be a more effective measure. In a central bank study released in December, officials said a reduction in public spending equivalent to 1% of Brazil’s economy would have the same effect against inflation as a rate increase of 1.25%.

Lower spending would also give the central bank room to make future rate cuts, a move that would likely soothe another growing concern—soaring interest in the real, Brazil’s currency. Rapid appreciation of the real against the dollar and other major currencies over the past year has hobbled the country’s exporters and made imports more competitive against homegrown goods.

Despite Ms. Rousseff’s vow to cut back, economists are urging the government to act quickly and more aggressively. Of particular concern to some critics is that many of Ms. Rousseff’s economic advisers, including Finance Minister Guido Mantega, come from Mr. da Silva’s administration.

That team, as spending soared last year, was harshly criticized for missing budget targets and using unexpected accounting maneuvers to make its deficit appear smaller than most economists reckoned. Among other steps, the government in the third quarter counted as revenue funds it had transferred from one federal agency to another as part of a massive capital increase for state energy giant Petróleo Brasileiro SA, or Petrobras.

“The recent reliance on accounting devices…does not bode well for fiscal credibility,” wrote Marcelo Carvalho, an economist at BNP Paribas, in a report last week. “While the authorities have pledged to pursue more disciplined fiscal policies, the challenge is to turn words into action.”