Brazil: Inflation and Interest Rates Down one More Time

Brazil has just reduced the benchmark lending rate for the seventh straight month, with inflation adjusted rates looking like they could fall below 10 percent next year, thus becoming the lowest since Lula da Silva took office. The 12-month inflation rate in November fell to 11 percent from 17.2 percent in the 12 months to May, while the monthly inflation rate has declined to 0.3 percent from 3 percent in November 2002, a month after Lula won election. The interesting question is why is this happening, and why is it happening in Turkey and numerous other places. The phenomenon seems to be global. So it isn't just a question of domestic good housekeeping. So what then is it?

Central bank policy makers cut the overnight target rate 1 percentage point to 16.5 percent to help revive economic growth. Based on Welch's assumption that the overnight rate averages 15 percent next year and inflation averages 6.2 percent, real rates would fall to 8.3 percent in 2004 from 12.7 percent this year.

The central bank's ability to reduce interest rates every month since June underscores Lula's success in fighting inflation during his first year as president. The lower rates are starting to revive South America's largest economy, which contracted in both the second and third quarters this year.

Welch, a former senior economist for the Federal Reserve Bank of Dallas who grew up in Brazil, expects inflation to continue to decline next year, enabling the central bank to lower rates further. He predicts real interest rates will drop to 4.1 percent in 2005, the lowest level in at least a decade, as the average inflation rate climbs back to 9.1 percent and the benchmark lending rate falls to an average 13.5 percent.................


Brazil's economic conditions may be changing in ways that will allow real interest rates to decline further, said Henry Stipp, who helps manage about $5 billion in emerging-market assets, including Brazilian bonds, at Threadneedle Asset Management in London.

Brazil had a current account surplus of $82 million in October, compared with a deficit of $7.7 billion in 2002. In the first 11 months of 2003, Brazil posted a record $22.1 billion trade surplus, compared with $13.1 billion last year and a deficit of $1.28 billion in 1999.

``We don't face a rush of having to finance our external needs in horrible conditions so that's paving the way for lower interest rates,'' said Stipp. ``People believe that this time real interest rates will remain for some time below 10 percent and the reason for that is because times have changed.''

An increase in U.S. interest rates from 45-year lows in the second half of next year might endanger Brazil's ability to keep cutting its own rates, said Ruggero de Rossi, who helps manage about $4 billion in emerging-market debt at OppenheimerFunds Inc. in New York. Growing demand in the economy may also turn Brazil's current account surplus into deficit and start to fuel inflation, putting pressure on interest rates.

``The difficult task will be in the second half of 2004 when the Fed hikes,'' said de Rossi.
Source: Bloomberg
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And if the Fed doesn't hike?