Brazil’s Economic Success leads to Inflation

Sources:
FT: Brazil resolute on rate rises to calm inflation
WSJ: Price of Success in Brazil: $15 Movies
IMF: Watching Out for Overheating in Latin America
CIA: World Fact Book, GDP Real Growth Rate

Over the past few years, Brazil’s Gross Domestic Product (GDP) has steadily increased, going from 3.70% in 2006, to 5.10% in 2008, and reaching 7.50% in 2010, making Brazil’s economy one of the most stable, and the country itself one of the wealthiest in South America and the western hemisphere. However, this success has not come without a price, as Brazil’s cities have become some of the most expensive in the world. The Wall Street Journal reported that Brazilians pay the equivalent of $15 for a movie, which is more than New Yorkers pay. Likewise, the jump in the price of food, transportation, and land has resulted in the inability of millions of poor Brazilians to maintain their standard of living as their income remains unchanged but the price of items continue to rise.

One reason for these rising prices is Brazil’s increasing inflation rate, which currently stands at 6.4%. In a statement issued earlier this month, President of Banco Central de Brazil, Alexandre Tombini, stated that Brazil will continue to increase interest rates for as long as necessary in order to drive inflation down to the target rate of 4.5% by 2012. The government continues to use conventional monetary policy in its effort to reach this goal. Such policy includes increasing taxes on lending and financial transactions in order to dissuade the flow of “hot money,” or speculative investments,into Brazil from abroad. “Hot money” occurs when investors attempt to ensure high short-term interest rates by taking their money from low interest rate yielding countries into higher interest rates countries as a way to obtain higher returns. Also, it can lead to lower savings rates and cause rapid overvaluation of the currency. These type of investments are particularly troublesome because as investors pull their money out of one country, in an attempt to profit off the exchange rate, it can shock the economic system and cause instability in that country. Likewise, speculative investments can lead to bubbles in certain economic markets such as real estate.

Two weeks ago, Brazil’s central bank increased interest rates by twenty-five basis points, to 12%. The increased interest rates will help to reduce the growth of demand in the economy, which in turn will slow growth and reduce inflation. Higher interest rates will reduce consumer spending by increasing the cost of borrowing and making it more attractive for citizens to save money. Although it is expected that such measures will decrease the month-on-month inflation starting as early as this month, the annual inflation rate might still continue to rise in comparison to the lower inflation rate of the corresponding period in the previous year. Nonetheless, for the time being, there is no indication that the Brazilian government will implement harsher capital controls such as the imposition of “quarantine on foreign investment” which, if implemented, would force investors to deposit a portion of their money with the central bank for a period of time.

Brazil is not the only country facing inflation and the risk of an overheating economy. In a report issued earlier this month, the head of the International Monetary Fund’s (IMF) Western Hemisphere Department, Nicolas Eyzaguirre, warned about the overheating risks facing many countries in Latin America.Rapid economic growth leading to an increase in demand and high levels of inflation are the main causes of an overheating economy. The problem is that if these overheating risks are not addressed, they can eventually lead to a recession. There are early signs of overheating problems in Latin American where countries that are facing rapid economic growth coupled with an expanding domestic demand, which has already led to inflation in much of the region. Although many central banks are increasing interest rates in order to deal with this problem, it is likely that more rate increases will be necessary in the future to contain much of the demand pressures.