Significance

At the monthly meeting of the central bank's monetary policy committee (Copom), the key selic rate was increased by a quarter-percentage point to 19.5%.

Implications

Although the move will have caught many off-guard, the magnitude of the increase suggests that the rate-hiking cycle is now at an end. The benchmark selic has been jacked up by 350 basis points since September 2004 and the economy is showing concrete signs of slowing.

Outlook

Higher domestic interest rates and a harsher international environment will combine to make this year a tougher one than last for the Brazilian economy. We expect GDP growth to slow from 5.2% to 4.2%, although the risks remain on the downside. 

Rate Hike Catches Markets Off-Guard

As ever, the central bank played its cards close it its chest ahead of its rate-setting meeting this month and managed to give out mixed signals in the process. Just last week, bank chief Henrique Meirelles said that inflation in Brazil was now under control, with many inferring from this that rates would therefore be kept on hold this month after the seven hikes of the seven preceding months. Indeed, the monetary authorities' latest Focus survey of private-sector analysts demonstrated that there was a consensus over a rate freeze this month and that no further tightening was expected in this cycle.

What, therefore, prompted the bank to strike once again yesterday? It is worth noting that Copom's decision was unanimous. As usual, the policy bias was set at neutral, meaning that no change in rates can be made ahead of May's meeting unless an emergency session is convened:

In the statement announcing its latest decision, the bank noted blandly that it was continuing the 'process of adjustment in the basic interest rate started at the September 2004 meeting.' This has seen the selic pushed up from 16% to 19.5%. The minutes of this month's meeting are due for release on 28 April.

Inflation expectations have climbed relentlessly in recent weeks. The benchmark Ibge-Ipca index - used by the bank for inflation-targeting purposes - is now seen ending 2005 at 6.10%, at odds with the official goal of 5.1% and forecast of 5.5%. However, it is below the 7% target ceiling espoused by the bank. (This ceiling is 2.5 percentage points above the original goal of 4.5%.) 

Recent inflation data have not been reassuring. The Ibge-Ipca posted a month-on-month (m/m) increase of 0.61% in March, compared to 0.59% in February. The 12-month rate stands at 7.54%. The IPG-10 index, meanwhile, rose by a sharp 1.17% in the 30 days to 10 April.

Losing the Battle, Winning the War?

Interest rate hikes in Brazil - more than in other countries - always provoke a chorus of protests from industrialists, union leaders and politicians alike as they rail against the growth-dampening effects of more expensive borrowing. All the same, there is good reason to believe that - barring any external shocks or an inflation surge at home - the current tightening cycle is at (or very close to) its end. Some observers, including ourselves, have been suggesting that a 25 basis-point hike (as opposed to the 50-point increases implemented in previous months) would indicate that the bank is drawing a line under its bout of rate increases. Moreover, despite sticky inflation and inflation expectations for the short term, the longer-term outlook is more positive: the latest Focus poll produces a consensus projection for end-2006 inflation of 5%, while the bank itself expects 3.8%. The official target is 4.5%, give or take two percentage points. The forecast for the next 12 months fell to 5.48% from 5.57%. Moreover, although headline inflation has proved stubborn, much of it has its roots in government-administered prices and increases linked to soaring world oil prices. The central bank, as Meirelles emphasised earlier this month, does not make its rate decisions on the back of price data from a month or two, although it would be disingenuous to argue that these do not play at least some part in the process. 

Outlook and Implications

The decision was announced after traders had left their desks. However, it may in the short term prolong the slide in stocks seen yesterday - the Bovespa stock index fell by 1.97% to 25.062 points on fears of accelerated rate hikes in the US. The real yesterday rallied by 0.5% to end the session at 2.56 reias:US$1, its strongest close since June 2002. The currency was underpinned by news that net foreign capital flows into the country were positive to the tune of US$1.310 billion during the first 11 working days of April and the latest rate hike could add a twist to the real's strengthening by boosting the appeal of Brazil's money markets.

Adding to the case that local interest rates are now at or very near their peak are recent data on the economic front, which indicate a significant slowing in activity in recent months. Industrial production in February, while up by 4.4% year-on-year (y/y), slid by 1.2% m/m . The overall decline reflects falls in 10 of the 23 sub-sectors that make up industry and follows a 0.6% m/m decline in January. Retail sales growth, meanwhile, slumped to 1.32% y/y in February from 6.24% the previous month. Although a key factor behind the sharp deceleration was the fact that this February had fewer working days than the same month last year, the interest-rate hikes implemented since September 2004 will also have played a key part .

The official GDP figures suggest that the peak of the current expansion was passed in the third quarter of 2004. Higher domestic interest rates are already eroding consumption growth, while the strong real poses risks to industrial activity by making import goods more attractive and reducing Brazil's competitiveness in overseas markets. The expected softening in global demand poses a further challenge. We therefore expect GDP growth to slow from 2004's buoyant 5.2% to a still robust 4.2%, although the risks remain on the downside.