Brazil makes largest rate hike in decades on fiscal concerns

The Central Bank of Brazil implemented its largest rate hike since 2002 on October 27, in a fresh bid to tame rising inflation and respond to concerns on fiscal sustainability.

The monetary policy committee unanimously voted to increase the key Selic rate by 150 basis points to 7.75%. So far this year, the central bank has increased rates by 575 basis points. Nonetheless, with inflation running high, real rates remain negative.

The mid-month inflation reading published earlier this week stood at 10.3% year on year, higher than expected. The central bank’s inflation targets are 3.75%​​ in 2021, 3.5% in 2022 and 3.25%​​​​ in 2023.

Against this backdrop, the committee said it foresees another rate hike of the same magnitude at its next policy meeting on December 8.

Fiscal focus

In addition to inflation pressures, the policy statement stressed that “further extensions” of fiscal policy in response to the pandemic that “deteriorate the fiscal path” may put pressure on the country’s risk premium. If investors pull back from Brazil, that could weaken the exchange rate and add to inflation.

The monetary policy committee pointed to recent government statements hinting at plans to circumvent fiscal limits. Such actions bring a “risk of de-anchoring inflation expectations, raising the upward asymmetry in the balance of risks”. The central bank warned “this implies a higher probability of inflation paths above the one projected under the baseline scenario”.

In October 2022, Brazilian president Jair Bolsonaro faces elections. Many observers say his path to re-election depends on sustained fiscal support for lower-income families.

Brazil’s public debt increased from 87% of GDP in 2019 to 99% in 2020, a very high level for a middle-income economy. This outlook could further worsen if the government implements Bolsonaro’s plan to double the size of Bolsa Familia, a cash-transfer programme for low-income households.

Brazil’s fiscal outlook “was the main factor that prompted the increase in the pace of tightening”, says William Jackson, chief emerging markets economist at Capital Economics. “We don’t see the fiscal risks that surfaced in recent days dissipating any time soon. Pressure for higher spending is likely to remain high in the run-up to next year’s election.”

More hikes to come

Unfavourable base effects that have boosted food inflation should soon start to fade, and core and energy inflation are expected to stabilise. However, “the headline rate will remain far above the central bank’s target until late next year, which will keep the door open for further tightening”, says Jackson.

The central bank says the balance of risks indicates it will be appropriate “to advance the process of monetary tightening even further into the restrictive territory”.

The institution foresees inflation at 9.5% at the end of this year, at 4.1% in 2022 and at 3.1% in 2023. This macroeconomic scenario assumes the Selic rate to rise to 8.75% in 2021 and to 9.75% during 2022, ending the year at 9.5%. The central bank expects it to drop to 7% during 2023.