Cutting Interest Rates in Brazil

Sources:
BBC: Brazil in Surprise Interest Rate Cut to 12%
Forbes: Brazil Lowers Interest Rates, but Risks Remain
MarketWatch: Brazil Stocks Hurt by Greek, Inflation Worries
Valor Econômico: Banco Central quis evitar ‘overdose’ na desaceleração
WSJ: Brazil’s Bank-Rate Boomerang
WSJ: Brazil’s Currency Unlikely to See Respite After Rate Cut
WSJ: Brazil Rate Cut Could Start Broad Anti-Recession Drive

This past week, Brazil’s Central Bank cut its benchmark interest rate—SELIC—to 12% from 12.5% to protect Brazil’s economy against the continuing effects of the global financial crisis. The Central Bank claims that a drop in trade or foreign investment could occur at any time and that decreasing interest rates makes economic sense as the global and Brazilian economies are slowing down. Cutting interest rates makes credit cheaper for both consumers and businesses who can then spend more money to drive economic expansion. At 12%, however, Brazil’s interest rate is still among the highest in the world.

Some analysts feel that the Bank is acting prematurely to guard against a global economic slow-down when it should be more concerned with domestic inflation. Although Brazil’s growth is slowing, it is still growing more rapidly than most other countries. Therefore, experts are concerned that Brazil acted to address a situation that does not reflect its economic reality. Brazil’s fast growth has pushed inflation to 6.9%, above the Bank’s target of 6.5%. Analysts predict that inflation will continue to rise and may reach 11% by 2012. However, the Bank believes that inflation will decrease as a natural side effect of slowing economic growth.

The Bank’s decision came on the heels of the Finance Ministry announcing a need for fiscal restraint, which prompted many critics to speculate that the government influenced the Bank’s decision, compromising its independence. One of the government’s main goals is to reduce the national debt. Lowering the amount of interest it pays on government bonds (Letras Financeiras do Tesouro or LFTs) would help accomplish this goal. The interest rate the Brazilian government has to pay on the bonds it issues is tied to the SELIC. Foreign investors fear that the Bank may sacrifice financially sound policies in favor of politically motivated strategies that may damage the economy. If investors lose confidence in the Bank’s independence, they may refuse to invest in Brazil, which would be devastating for the country as it needs foreign investment to finance infrastructure improvements ahead of the 2014 World Cup and 2016 Olympic Games.

The cuts have already had an impact on the market, although not for the better. Finance and real estate companies that depend on high interest rates to make a profit saw their stock prices fall after the announcement. Some economists believe that cutting interest rates will not solve Brazil’s economic problems. Cutting interest rates by only 0.5% will not substantially impact the the government’s debt payments. Furthermore, cutting interest rates poses the risk of increasing inflation. Though the increased spending—spurred by lower interest rates—may drive economic expansion, it may also increase inflation if production cannot keep up with the new demand. Since the Central Bank’s main task is to control inflation, it is easy to question whether the Bank has lost sight of its objective.