Brazil joins China on the road to higher inflation--and higher interest rates

04/14/2010 2:00 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

China isn’t the only developing economy facing inflation pressures. Economists are projecting that consumer price inflation in Brazil will hit an annual rate of 5.2% this year. That’s well above the government’s target of 4.5%.

The central bank is expected to start raising interest rates as early as its next meeting on April 27. The target overnight interest rate, known as the Selic, is projected to hit 11.25% by the end of the 2010, up from 8.75% now.

All economies have what’s called a speed limit to growth. Growth rates below the speed limit don’t push up inflation at rates faster than the central bank will tolerate. Above the speed limit growth produces dangerously high rates of inflation.

For the United States right now that speed limit is somewhere around 2.5% to 3.5% depending on what economist you talk to.

For Brazil’s developing economy the speed limit for growth seems to be somewhere around 4.5% to 5% right now. The Brazilian economy is on track to grow by 5.5% in 2010. Hence the need to slow growth by raising interest rates.

Why do economists think Brazil is in danger of exceeding its economic speed limit?

Brazil’s factories are running at almost full capacity. When a company uses the last bit of its production capacity it has to put older and less efficient machinery to work. That inefficiency leads to higher costs that eventually get passed on as higher prices.

Even though unemployment was still at 7.4% in February the labor market is now tight enough to produce wage increases at a pace that exceeds productivity growth. Any economy has pockets of potential workers with skills that don’t match an economy’s needs. As cruel as it sounds, these workers are for all intents and purposes permanently unemployed. (Better education sand training can over time reduce the number of permanently unemployed.) When an economy can’t find more workers with the right mix of skills—no matter the unemployment rate—wages start to rise for those workers with needed skills. That’s happening in Brazil right now.

And finally any fast-growing economy runs into bottlenecks as growth speeds up. Ports aren’t able to handle all the ships that need to be loaded or unloaded. Goods have to sit in warehouses waiting for trucks. Congestion ties up highways. All that increases costs throughout the economy. And such bottlenecks are especially hard to avoid in a developing economy that’s building infrastructure as fast as it can—but still lagging behind demand.

Multiply what’s happening in Brazil—and China—by all the world’s other developing economies and you can understand why global inflation and global interest rates are headed higher in 2010.

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