Brazil Raises Rates to Stem Inflation From Real's Slide
By JONATHAN KARP, Staff Reporter of THE WALL STREET JOURNAL, October 15, 2002

SAO PAULO, Brazil -- The Central Bank abruptly raised its benchmark interest rate to 21% from 18%, a politically unpopular move less than two weeks before Brazil's presidential vote and one that underscores the severity of financial problems confronting Latin America's biggest economy.

In its first emergency session in four years, the Central Bank said it raised rates to stem inflation caused by the "steep depreciation of the exchange rate." Brazil's currency has lost 40% against the dollar this year, and 6.2% since Oct. 6, when left-winger Luiz Inacio Lula da Silva won the most votes in the first-round presidential vote. The move is certain to hurt government candidate Jose Serra, who already faced criticism for stiflingly high borrowing rates. The latest opinion polls show Mr. da Silva easily winning the Oct. 27 runoff.

Marcelo Carvalho, chief economist for Bank of America in Sao Paulo, said the surprise move displayed both "boldness" and "despair" by Central Bank Governor Arminio Fraga, who has faced criticism for not doing enough to quell recent financial-market turmoil. "It's meant to reaffirm his credibility by conveying the right signal on inflation targeting despite the political calendar," he said. "But it's a tough [market] environment, and it doesn't look like this move alone will contain the currency" from falling further.

The real weakened to 3.86 to the dollar, compared with Friday's close of 3.82. Brazil's benchmark stock index lost 4.6%. The interest-rate increase, which followed tough measures Friday to crack down on currency speculation, fell short of economists' predictions.

"I was expecting more-aggressive action," said Marcelo Salomon, Brazil economist at ING Barings in Sao Paulo, who thought the benchmark Selic rate would be raised to around 25%. The Central Bank's next scheduled interest-rate meeting comes next week, just days before the presidential runoff. "We can't rule out another hike in rates if the currency continues to deteriorate," he said.

Brazil's interest rates are among the highest in the world, and raising them further will sap economic activity and increase Brazil's debt burden. Half of the government's domestic debt is indexed to interest rates. But the key driver of interest-rate policy is inflation, and the Central Bank boosted rates to damp the inflationary effects from the weakening currency. The government is almost certain to miss its annual inflation target of 5.5% for 2002.

Monday's interest-rate rise did little to calm volatile markets, which were aggravated by an accident at an offshore rig owned by state oil giant Petroleo Brasileiro SA, or Petrobras. Also weighing on investors was concern about the Central Bank's ability to roll over more than $3 billion in domestic debt by Thursday.

In its first response to the Central Bank's decision, Mr. da Silva's Workers' Party sought to blame the government for the need to raise interest rates. But party president Jose Dirceu also sought to appease investors by pledging support for legislation that would give the Central Bank "operating autonomy" to insulate monetary policy from political pressure.


Questions:

  1. Do you think that the effect of this interest rate increase will be to raise the value of the real?  Why?
  2. What would you say to those who are worried about the impact of the rate increase on Brazilian GDP?  What, do you expect, will be the indirect effect of the rate increase on the exchange rate, through its impact on GDP?  Explain the effect.
  3. Which of the two effects, do you think, will predominate?
  4. The Wall Street Journal announced that "The real weakened to 3.86 to the dollar, compared with Friday's close of 3.82. Brazil's benchmark stock index lost 4.6%." Although this seems to support the argument that the negative GDP effect is larger, present arguments to show that this evidence is not conclusive.
  5. The inflation rate is between 5% and 10% in Brazil.  Why, then, should the nominal interest rate be as high as 18% or 21%?  This suggests a real rate of, around, 10%, which is extremely high.  Analyze and explain.
  6. The Workers' Party pledged to give the Central Bank more autonomy.  Is this important?  Why or why not?