Brazil’s central bank decided to focus on growth rather than inflation, which will likely result in stronger growth next year. The US monetary policy could have an impact on Brazil’s exchange rate.
The Central Bank of Brazil has been easing monetary policy in order to boost growth, having decided that the slowdown in economic activity is more worrisome than the level of inflation. Yet going forward, the central bank will have to find the right balance between the goals of higher growth and lower inflation, lest one of the goals becomes unattainable. Moreover, with the US Federal Reserve having initiated a third round of asset purchases (quantitative easing), Brazil is one of many emerging countries to be concerned that the US policy will cause a boost in the value of the local currency. Brazil’s policy will thus aim to also keep the currency competitive.
The central bank has cut the benchmark SELIC rate 11 times in the past year. The rate has declined by 525 basis points, reaching a record low of 7.3 percent in September of this year. Although economic growth remained feeble during the first half of 2012 (real GDP was up only 0.5 percent in the second quarter, lower than a year ago), there are signs of economic renewal. Unemployment has fallen to a record low of 5.5 percent. Moreover, while second-quarter GDP was hardly up from a year ago, it did grow at an annual rate of 1.6 percent from the first quarter, a significant improvement from earlier quarters and the fastest rate of growth since early 2011. Thus, the easing of monetary policy is evidently working despite negative global headwinds. Indeed, second-quarter growth improved despite severe export weakness.
Not only has monetary policy been eased, fiscal policy also has contributed to growth. The government has cut the interest rate charged by its development bank. It has also boosted spending on public investment, provided tax incentives for consumer spending on durable goods, and sold concessions for private sector development of public infrastructure.
With stimulation from both the Central Bank of Brazil and the government, domestic demand, including both consumer spending and public investment, is picking up.
Meanwhile, inflation remains slightly higher than the central bank target of 4.5 percent. In September, consumer prices were up 5.3 percent from a year ago. Moreover, this was the third straight quarter in which inflation accelerated. All these indicate a developing problem.
The other big issue is the currency. During the past year, as interest rates were cut, the Brazilian real declined by 22 percent against the US dollar. While a cheaper currency tends to be inflationary, it also leads to more competitive pricing of non-commodity exports. This has been seen as a good offset to the weakness in global demand for Brazilian exports. Yet, the recent decision by the US Federal Reserve to engage in a third round of quantitative easing will, it is feared, cause the Brazilian real to increase in value. This was the fear two years ago during the last round of asset purchases by the US Federal Reserve. At that time, Brazil imposed a tax on inbound portfolio investment to discourage a rise in the currency. This time around, the government has chosen to impose a new round of capital controls on portfolio investment that aim to discourage hot money from flowing into Brazil. One effect of these controls has been to shift inbound money from portfolio to direct foreign investment. Despite weakness in the global economy, foreign direct investment has remained strong.
What can be expected going forward? It seems likely that Brazilian growth will recover in 2013, barring a deeper crisis in Europe or a recession in the United States. With stimulation from both the Central Bank of Brazil and the government, domestic demand, including both consumer spending and public investment, is picking up. With lower interest rates and increasing foreign direct investment, private sector investment should pick up in 2013. Moreover, Brazil is now seen as a favorable location for investment in energy, manufacturing, and offshored services.
On the other hand, there are a few things that worry observers: rising inflation, increased protectionism on the part of the government, a rising fiscal deficit, and the continued weak state of the global economy. Protectionism has involved a variety of government regulations aimed at boosting the domestic content of manufactured goods. Historically, such rules have tended to encourage inefficiency, reduce productivity growth, and often contribute to inflationary pressures. The fiscal deficit could become worrisome if it is financed through monetary creation (which causes inflation) or if it leads to higher market interest rates (which would discourage private sector investment). If, however, growth accelerates sufficiently, that in itself could relieve the fiscal deficit by driving an increase in tax revenue.