The first move during Rousseff’s second term
On October 29, the central bank’s monetary policy committee in Brazil raised the benchmark Selic interest rate by 25 basis points to 11.25%. The increase was an attempt to fight inflation.
On November 6, the bank announced that there will be another 25 basis point hike next month. The hikes could also provide the government with an option to raise fuel prices. This would help Petrobras recover from policies that forced it to sell imported fuel at a loss in order to cap inflation. Petrobras is a state-run oil company.
According to the bank, the move was intended “to guarantee, at a lower cost, a more benign scenario for inflation in the next two years.” Brazil’s inflation is hovering above the official target ceiling of 6.5%. This put pressure on the central bank to raise borrowing costs.
The central bank wants to keep inflation at the center of the target—between 2.5% and 6.5%. This has to be done without dragging the Brazilian economy back into recession.
Brazil fell into a recession in the first half of the year. Although the government expects that the economy to rebound in the second half of the year, economists expect Brazil’s gross domestic product (or GDP) will expand at less than 0.3% in 2014. It only expects GDP growth of 1% in 2015. A lot more needs to be done to make Brazil’s growth increase quicker.
An upward and downward trend in growth in Brazil is reflected in the performance of the iShares MSCI Brazil Capped ETF (EWZ). The EWZ invests in Brazilian equities—like the oil giant Petroleo Brasileiro SA Petrobras (PBR) and the mining firm Vale SA (VALE). It tracks broad market performance in Brazil—much like the WisdomTree India Earnings Fund (EPI) for India and the VanEck Vectors Russia ETF (RSX) for Russia.
Threat of a credit downgrade
Rate hikes are used to control inflation. However, rate hikes also curb economic activity. Brazilian exchange and stock markets have been volatile since Dilma Rousseff’s re-election victory. Investor expectations are tied to more business-friendly policies coming from her under the threat of a credit downgrade.
To avoid a credit downgrade, Rousseff’s new economic team may also need to tighten the federal budget. A decrease in public spending would also help ease inflationary pressures. However, the electoral mandate of Rousseff’s Worker’s Party advocates public spending. Rousseff’s government may find themselves in a catch-22 situation if and when they face a credit downgrade.
To learn more about Brazil’s credit rating and how it’s susceptible to a downgrade, read our earlier Market Realist article “Why Brazil’s sovereign debt is rated 1 notch above junk.“