Brazil's new central bank president steps on the brakes with a 50 basis point interest rate increase

01/21/2011 1:30 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Not as bad as the worst forecasts, but the January 19 0.5 percentage point interest rate increase from Brazil’s central bank does promise that Alexandre Tombini, new president of the Banco Central do Brasil, is going to aggressively raise rates to fight inflation.

Before the bank’s decision there had been speculation in Brazil that Tombini would seek to put his mark on bank policy by going for a 0.75 percentage point interest rate increase in his initial move as bank president.

But instead the bank settled on a still emphatic 0.5 percentage point move and some very pointed language: The increase was the beginning of “a process of adjustment in the benchmark interest rates whose effects, coupled with macro-prudential measures, will contribute to a convergence of inflation to the target trajectory.”

To translate (Hey, do you think the Banco Central could give lessons to the Fed on obfuscation?), we’re going to raise rates until inflation, which ran at 5.91% at the end of 2010, comes down to the bank’s target of 4.5%, plus or minus 2 percentage points. And the bank expects that the national government of new president Dilma Rousseff will cut the federal budget beginning next month, as promised, if not sooner.

How high could interest rates go in 2011? Yesterday’s move raised the benchmark Selic rate to 11.25% and the futures market is betting that the bank will take interest rates to 13.25% before it’s done.

An interest rate increase of that dimension is probably necessary to bring inflation under control, but it’s going to deliver even more pain to Brazil’s already suffering manufacturing and export sectors. Higher Brazilian interest rates will push up the country’s currency, the real, even further, costing Brazil’s exporters overseas customers and making it harder for domestic producers to compete with cheaper imports. The real is up 40% in the last two years.

Currency controls and direct market intervention will help slow the appreciation of the real, but ultimately it will take a rapidly deteriorating foreign trade balance and the approaching end of the cycle of interest rate increases to push the real back down. That would take most of 2011 to achieve.

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