By Alfredo Coutino, Senior Economist, Latin America
Moody’s Economy.com. West Chester, PA, USA.
April 18, 2008.
Contrary to what we expected, the Central Bank of Brazil tightened monetary policy in April, in an effort to control the deterioration of expectations in light of a gradual inflation rebound in the year.
Inflation has shown a mild increasing trend, but it still stays around the target and far below the upper limit. However, the market was clamoring for a hike since they expect a continuous inflation rebound in coming months, thus the central bank acted more to accommodate market pressures. Hence, the monetary policy committee decided to raise the benchmark Selic rate by 50 basis points to 11.75% on April
16, interrupting the six-month pause which started last October after a two-year relaxation cycle. The bank also left the door open for additional rate hikes during the year.
Certainly, in the past few months inflation has shown a mild increasing trend, coming from 4.5% last December to only 4.7% in March. The inflation rebound is practically insignificant, particularly because inflation is still around the inflation target of 4.5%. This fact, by itself, does not justify the central bank’s tightening decision, because inflation is still far below the upper limit established at 6.5%. There are two more reasons to believe the central bank precipitated in its decision.

Well-Behaved Inflation
CPI, annual %
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
Central target
Inflation
Upper limit
Lower limit
Source: IBGE
07 08
On one hand, economic growth continues to advance supported by a solid domestic market and favorable external demand for commodities. Even though monetary conditions are restrictive, the economy continues to expand at solid rates, thus allowing the national production to match the advance of demand. Indeed, the domestic absorption in real terms is still lower than the national production.
Under these circumstances no excess demand has been generated and consequently inflation is not a demand-driven problem, which introduces doubts about the bank’s action.
On the other hand, monetary conditions were already in the restrictive zone, since the nominal Selic rate was far above the neutral rate estimated at 9.00%. With the recent move, the rate is even more restrictive of economic activity. In fact, the real interest rate has increased to 7.0%, one of the highest and most attractive rates among emerging markets. Even more, since rates in the U.S. have decreased, the yield gap has increased to 9.50 basis points and is expected to continue widen, thus keeping the attractiveness of Brazilian bonds to foreign investors. This, obviously, is going to impose more revaluation pressures on the Brazilian real, which at the end might have a positive effect on inflation, but it will also impose the risk of external balance deterioration later.

Restrictive Monetary Conditions
Monetary policy rate (Selic), anual %
14.0
13.5
13.0
12.5
12.0
11.5
11.0
10.5
10.0
9.5
9.0
8.5
8.0
Restrictive
Zone
Neutral
Zone
Selic
Source: Banco Central do Brasil
07 08
In fact, since there is no real inflation problem in Brazil and monetary conditions were already restrictive, the central bank's move seems to be in the wrong direction. Thus, the central bank’s panic is mainly explained by the recent reduction of the exchange rate gains on inflation. In this regard, the justification could be the fact that the central bank is mostly interested in keeping the currency revaluating for whatever reason.
Monetary tightening is only effective if inflation is driven by demand factors, which is not the case of Brazil. The economy does not suffer of an excess demand; on the contrary, it has an excess supply. In this regard, the interest rate hike is not going to be effective to fight inflation but only to restrict economic activity more, which could induce a more remarkable deceleration of growth in coming months.
Under the expected environment of global slowdown, if authorities want the economy to grow at its natural rate, monetary conditions should resume the relaxation cycle and move the rate to the neutral zone. In the end, more flexible monetary conditions will be needed this year to strengthen the domestic absorption, which will let the economy to mitigate the negative impacts of the U.S. recession. Thus, the strength of the domestic market will contribute to compensate for the moderation of the external demand. But also, lower interest rates will help reduce the currency revaluation and move the Brazilian real to a more competitive position. This will allow the country to keep the pressure of domestic demand stimulating the national production instead of letting it escape to the outside through more imports.

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Service, Inc., the credit ratings agency which is also a subsidiary of MCO.
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