Inflation drops (a bit) in Brazil bringing an end to central bank rate increases just a little closer

06/09/2010 11:02 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Inflation dropped in Brazil in May.

For the 12 months ended in May consumer prices rose at a 5.22% annual rate. That’s a drop for the 5.26% annual rate recorded in April. This is the first decline in Brazil’s inflation rate in seven months.

The slowing of the pace of inflation isn’t likely to deter Brazil’s central bank from raising interest rates later today. The consensus among economists is for an increase of 0.75 percentage points. That would take Brazil’s benchmark Selic rate to 10.25%. Even at 5.22% inflation is running ahead of the central bank’s 4.5% target for inflation this year.

But the slowdown in inflation plus the decisive action on interest rates by the Banco Central do Brasil—the central bank raised interest rates 0.5 percentage points last month--has raised financial market expectations that Brazil will be able to get inflation under control without tanking economic growth.

The Brazilian economy grew at a 9% annual rate in the first quarter of 2010; economists expect to see—and hope to see--slower growth in the second quarter. JPMorgan Chase has projected a 7.5% economic growth rate for the entire year.

In a sign of confidence that central bank policy will succeed in controlling inflation, the difference between overnight interest rate future contracts due in January 2011 and those due in January 2013 narrowed to 1.01 percentage points this week. That’s the smallest gap in 14 months and pretty much wipes out the 0.43 percentage point increase in the size of the gap in April. In that month financial markets seemed to be signaling a loss of faith in the central bank after it failed to raise interest rates in March.

The fall in inflation and the size of today’s interest rate increase are key to figuring out when to buy into Brazilian stocks. Stock prices are likely to remain under domestic pressure—plus whatever penalty the euro debt crisis imposes on share prices in emerging markets—until the Banco Central do Brasil reaches the end of its interest rate increases. The consensus before today’s inflation number was that the bank wouldn’t stop until the Selic rate was 12% or so.

 If inflation continues to decline, albeit modestly, and the bank continues to eat up the interest rate turf with 0.5 and 0.75 percentage point increases, the end to the bank’s rate increases may be closer than the end of 2010 target assumed by the consensus earlier this year. Much closer.

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