The financial crisis that started at the end of 2008 had a near-immediate contractionary effect on the real economy. The government and the Central Bank of Brazil have acted quickly, and after a moderate contraction of -0.33 percent in 2009, Brazil’s growth was 7.53 percent in 2010, becoming the world’s seventh-largest economy.

In 2009, some measures were introduced to incentivise consumption, credit and production. Events in the year that followed were a direct reaction to these measures. It was necessary to adopt new actions of fiscal and monetary policy, but this time to make them contractionary, because the economy was moving towards a growth of over seven percent, well over its potential, generating inflationary pressures.

A strong year for Brazil
In an economy that uses an inflation target regime, the actions of the monetary policy are guided according to the existing inflationary risks. Despite a high interest rate in some months of 2010, Brazil got into 2011 with an inflation rate pressured by internal heated demand and the high price of commodities. As a result, the Central Bank had to reinstall a high interest rate in order to undo the compulsory measures adopted in December 2008 and in order to adopt macroprudential measures in the area of credit. The Central Bank were innovative when adopting prudential measures, and were subsequently criticised by financial agents because of it.

The difficulty in evaluating the contractionary effect of these macroprudential measures brought up some uncertainty in the market, resulting in a high interest rate. The third quarter of 2011 was predicted to see a slowdown in growth by around four percent. Accordingly, the months following August saw a significant contraction in activity despite revisions that were put in place to secure GDP growth for the whole of 2011 – expected at the time to be between 2.8 and three percent.

The BCB’s forecast of a cooling in activity amidst the deteriorating international crisis enabled the institution to correctly anticipate the market volatility, surprising financial agents, who then met one another and did something they had never done before, increase the interest rates. After instigating a rise in the interest rate by 0.25 p.p. in a meeting held in July, the BCB reduced the Selic tax by 0.50 p.p. in a meeting held in August. At the time, the decision was considered to be risky and was criticised, in hindsight however, the move appears to have been a shrewd one.

Despite an expected slowdown in its Gross Domestic Product, Brazil may reach a new position in the global ranking and overtake the UK, becoming the world’s sixth-biggest economy in 2011 according to CEBR, a British economic studies entity.

The mire of developed countries
The year 2012 has started with a slow domestic economy, low interest rates and the government adopting measures to stimulate the industrial sector and overall consumption. The BCB is undoing some macroprudential measures taken out in 2011 in order to keep the area of credit robust, inflation at a steady level over the next 12 months and to restructure the expectations of the BCB and other economic agents in relation to the inflation level in the mid-to-long-term future, regardless of the uncertainty concerning the slow development or adverse situations that might occur in the developed economies.
It’s the factors in other parts of the world that are currently causing the main problems as it is these external forces that are the main drivers for the decisions made by the Central Bank and the government of Brazil – decisions that are presently slowing down growth in the economy as business confidence weakens and credit ceases to flow to businesses on the ground.

The uncertainties surrounding the region are numerous: A risk of financial disruption, the new capital requirements of Basel, the actual conditions under which public and private sectors will meet to refinance their debts this year, i.e. the situation the eurozone finds itself in is one never seen before, and as such, world leaders are unfamiliar with how to deal with the crisis which only seems likely to worsen. The situation requires the global economy to adopt preventive measures, despite not knowing for sure what legacy the fiscal crisis will leave on the region and its impact on other economies.

With the world’s financial stability in limbo and a weak domestic economy, the Central Bank needs to adjust its monetary policy. This is another challenge for Brazil, as the adjustments in the interest rates are difficult to measure, resulting in the country going through high/low SELIC rates. There’s always a rush in order to correct the direction of the economy, sometimes stimulating when the level of inflation allows it to be, and sometimes contracting when there are target regime risks.

In 2012 the expectations regarding interest rates differ from that of the market, with forecasts varying from nine to ten percent by the end of the year. The external sector bestowed strong influence on Brazil’s monetary policy, whether the situation in these developed countries improves or not will either limit or enhance cutting the interest rate.

The high cost of inflation
The third problem the Central Bank and the government face is inflation. At the moment, there is a divergence between the BCB and the market’s expectations regarding the Consumer Price Index (CPI) closing in 2012 and the following years to come. From the BCB’s point-of-view, the realisation of a positive outcome regarding the international crises will result in a CPI rate next to its target of between 4.5 and 4.8 percent. But economists don’t believe that inflation will be below five percent and have estimated it will accelerate in 2013, depending on the level of interest rate in 2012, government incentives and of the accomplishment of other fiscal targets.

All the facts are linked. An extreme situation in Europe or a lower risk aversion in the region will affect the monetary policy decisions in Brazil, with a consequent effect on inflation dynamics. Icap Brazil hopes that SELIC closes the year with a 10 percent rate, an inflation rate of 5.19 percent against 6.5 percent in 2011 and growth in the economy of around 3.4 percent, still below its potential, but above last year’s result.

The forecasts are susceptible to revision but the main expectation is the cooling of inflation – without meeting the main target – a recovery of activity and of GDP, a quick adjustment in the interest rates followed by stability throughout the year and without a liquidity crisis similar to the one seen in 2008.

For more information please contact Inês Filipa at: Ines.Filipa@br.icap.com