In Brazil's inflation fight January actions will speak louder than December words

12/03/2010 3:51 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Brazil’s President-elect Dilma Rousseff would like to convince the financial markets that she’ll keep her promise, made in her October 31 victory speech, to cut taxes, reduce government spending, and control inflation.

Her two top financial appointments so far send a mixed message, however.

Dilma will keep Guido Mantega, as finance minister, a post he’s held from 2006. Mantega did a good job during the financial crisis at increasing government spending to avoid the worst of the crisis for Brazil. But the spending continued during the election and that’s one reason inflation has risen to 5.2%.

Mantega belongs to the wing of Dilma’s Workers’ Party that favors a big role for the government in the economy. That makes the markets, which fear that Dilma shares that approach, nervous. In recent days Mantega has talked about freezing a portion of the 2011 budget and actually reducing spending for some ministries. But that might not be enough to convince investors who note that Brazil showed a surprise budget deficit in October.

More significant than the proposed budget freeze, which would touch spending equal to only 0.5% of Brazil’s GDP, are promises to cut in half the loans the government provides to the state-owned BNDES development bank. The bank, Brazil’s largest provider of long-term credit, has doubled its own lending from 2007 to 2010.

The market may be counting on Dilma second appointee, Alexandre Tombini, to balance Mantega. Tombini, who helped draw up Brazil’s inflation-targeting rules a decade ago, is Dilma’s nominee to head he central bank.

His first real test (Real, get it?) will come in January. An increasing number of economists are expecting that the Banco Central do Brasil will begin raising interest rates early in the new year to fight inflation. The bank has raised its Selic benchmark interest rate to 10.75% in the last two meetings after taking the rate to a record low of 8.75% early in 2010. Those two interest rate increases haven’t stopped inflation from climbing and economists now think the bank will take rates to 12.75% by the end of 2011.

That move wouldn’t be politically popular, which is why the financial markets are so keen to see if Tombini follows through on the interest rate increases started by Henrique Meirelles, the departing head of the bank. Under Dilma’s predecessor Luiz Inacio Lula da Silva, Meirelles had freedom to set bank interest rate policy without political intervention from the president.

Dilma has said she wants to see the real benchmark interest rate fall to 2% by 2014. (At 10.75%, the real benchmark rate, that is after inflation, is currently 5.3%.) Getting interest rates that low with without allowing inflation to rage out of control will require much bigger budget cuts than Mantega has so far proposed.

The jury is still out on the new administration. But January should bring some clarity as actions follow up on words.

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