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Producer rise in prices driving Brazil’s inflation is problematic

Brazil IGPEnlarge GraphBrazilian inflation has remained high over the past few months due to wholesale price rises. Investors in Brazil track inflation closely because the Brazilian Central Bank aims to maintain inflation within a specified range. Inflation generally increases as a result of fast economic growth and when inflation wanders outside of the range, the central bank increases interest rates to suppress it, along with economic growth. Once inflation subsides, rates are lowered again to promote growth.

The Brazilian Institute of Economy publishes the monthly General Price Index (IGP), which is an inflation index composed of three sub-indices: IPA, IPC and INCC. The IPA is a wholesale price index which measures producer price inflation and accounts for 60% of the IGP. The IPC is a retail price index, which measures the consumer prices inflation and accounts for 30% of the IGP. Lastly, the INCC is a construction price index, which measures the inflation in construction costs and accounts for 10% of the IGP.

The graph above shows how the three components have changed over the past six months. The yearly inflation as of January 2013 was 7.9%, relatively unchanged vs. December and 1.2 percentage points higher than six months ago. The graph shows that the main driver behind the inflation over the past six months was the producer prices, which went from 7.0% to 8.3%. The consumer prices went up by just 0.3 percentage points and construction went down by 0.4 percentage points.

The important message from the graph is that input prices are rising much faster than output prices meaning that production costs are rising but the revenues from the products sold are not increasing as fast. If businesses are unable to pass along to the consumer the elevated cost of inputs, the profitability margins will be squeezed, and this will be reflected by a drop in the equities market.

Additionally, if inflation remains high, the central bank may raise interest rates at their next meeting in early March and the stock market would react negatively. Investors following Brazil, such as those invested in EWZ or Brazilian small caps such as EWZS and BRF, should follow inflation closely to anticipate changes in interest rates. Investors in EEM and VWO should also take note since Brazil accounts for over 10% of the exposure of their ETFs.