Brazil’s Rate Hike Campaign Chokes Economy in Warning to Fed
Brazil’s 10.75%-and-Rising Rates Bite Economy in Warning to Fed
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Eleven months into Brazil’s breakneck cycle of interest-rate hikes, the economic damage is piling up.
Families are choking on debt, earmarking more than half of their monthly budgets to meet rising payments; the boom in IPOs, a key source of funding for growing industries, has ground to a halt as investors funnel cash into suddenly attractive government bonds; and the economy has slipped back into recession less than a year after emerging from the pandemic collapse.
It’s a reversal of fortune as abrupt as the monetary tightening cycle itself -- and precisely what policy makers in the U.S. and Europe are trying to avoid as they too seek to quell the inflation outbreak that has taken hold across the globe.
Just eighteen months after Brazil’s central bank cut its benchmark rate to an all-time low of 2%, it stands today at 10.75%. Even in a region where policy makers have shown an uncommon zeal this past year for tackling inflation, this rate-hiking campaign stands out. And it’s not over yet: There will almost certainly be at least one more hike, helping cement expectations in financial markets that the rate will remain in double digits for years to come.
“Brazil will deal with higher rates for a long time,” Felipe Guerra, a founding partner at hedge fund manager Legacy Capital, said at an event hosted Credit Suisse Group AG, citing concerns about public spending. “The outlook for emerging markets is challenging, and Brazil has a bad inflation history.”
Higher rates have quickly revived the U.S.-Brazil carry trade that for decades allowed investors to borrow in U.S. dollars to invest in higher-yielding Brazilian bonds, as the country consistently sustained some of the highest interest rates in emerging markets.
But they’re having a slower impact on inflation. While expectations for 2023 have just stabilized above the 3.25% target, prices in January still rose at an annual clip of 10.38%, the national statistics bureau reported on Wednesday. More expensive food accounted for nearly half of the month’s inflation, hurting families’ purchasing power and President Jair Bolsonaro’s popularity just as he prepares for his re-election campaign.
Budget Fears
In fact, concerns about runaway public spending both before and after October’s presidential election are now the main reason why inflation expectations remain above target.
Last year, Bolsonaro further undermined the austerity agenda of Economy Minister Paulo Guedes by pushing for changes to a rule that caps public spending to make room for more cash transfers to the poor. This year, he’s seeking a reduction in fuel taxes that would hurt government revenue, while pledging higher salaries for some civil servants.
Policy proposals from his main rival, former President Luiz Inacio Lula da Silva, don’t look too promising for inflation control either. His top advisers have laid out plans for massive infrastructure investments and more robust social programs, and Lula himself has criticized the country’s spending cap.
Worried about Brazil’s fiscal outlook, the central bank on Tuesday warned its tightening cycle may need to be more restrictive than originally thought. Economists immediately understood the message, revising up their key rate forecasts to more than 12% at the end of the cycle.
What Bloomberg Economics Says
“Without a fiscal anchor, Brazil faces the risk of living with double-digit rates even after the tightening cycle comes to an end. The absence of a clear, sustainable fiscal path not only means higher neutral real rates, but also increases the uncertainties on the inflation path. That reduces investors’ willingness to finance the government through single-digit long bonds.”
-- Adriana Dupita, Brazil economist
Brazil has a few possible solutions to put public debt under control, said JPMorgan Chase & Co’s economist Cassiana Fernandez.
“It either controls public spending, or increases revenue through higher taxes or faster growth, or it has more inflation,” she said. “We’ll likely have a combination of all those things and that will determine how much the central bank will be able to cut interest rates in the future.”
Overkill
Brazil’s monetary policy U-turn raises questions about central bank chief Roberto Campos Neto’s strategy to go further than all his predecessors in cutting the Selic to 2% in 2020. As the economy began to reopen late that year, things seemed to be heading in the right direction, as activity, debt levels and tax collection all improved.
It seemed doable, until it wasn’t. Swelling domestic demand and higher commodity costs worldwide forced the bank to start tightening monetary policy with a bigger-than-expected rate hike last March. It then had to speed up the tightening pace when fiscal concerns moved to the forefront.
Reforms implemented since 2017, like the public spending cap and a pension overhaul, helped to avoid the extreme swings of tightening and easing of the past. So-called neutral interest rate levels, which neither stimulate nor restrict economic activity, were as high as 6.5% before such reforms. Now they are closer to 4%, but rising.
Campos Neto’s team risks hurting the economy by hiking rates too high, as it focuses on analysts’ inflation expectations that reflect strong fiscal risks instead of its own models, said Tony Volpon, a strategist at Wealth High Governance and a former central bank director.
Volpon was among the few economists who cautioned Brazil’s key rate had fallen too low. Now he is warning that the central bank needs to avoid being too hawkish.
“You can’t fix one mistake by doing the exact opposite one,” he said.
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