Brazil & Southern Cone - 26 October 2004

President Lula da Silva and the government are putting on a brave face after the central bank's monetary committee (Copom) decided on 20 October to increase the basic interest rate, the Selic, by 0.5 of a percentage point to 16.75% annually.

The markets were expecting an increase in the Selic after Copom said at its previous meeting on 15 September that it would start a 'gradual period of readjustment to contain inflationary pressures'. At the time, Copom had decided to raise the basic interest rate by 0.25% after the central bank announced it would also increase its previous inflation target for 2005 from 4.6% to 5.1% due to high oil prices in the international markets. However, no one, not least the government, expected the Copom to raise the Selic by 0.5%.

At its last meeting, the Copom made it clear that increasing the Selic was necessary because inflation in the month of August had reached 0.69%, bringing the accumulated inflation index 0.36 percentage points short of the central bank's 5.5% target for 2004. This time, however, the Copom did not explain its motives, announcing only it had decided to 'readjust the Selic moderately' and that the decision was supported by all the committee's members. The Copom has always reiterated its main concern is to avoid an 'inflationary contamination' in the economy. However, after a sharp increase in August, inflation closed the month of September at a healthy 0.29%, according to the trade-union-linked Dieese - the lowest level since April. The Fundacão Instituto de Pesquisas Aplicadas (Fipe) also registered a fall in the inflation rate, 0.21% in São Paulo's metropolitan region in September, after hitting its highest level of 0.99% in August. Fipe expects an inflation rate of 0.40% in October.

The impact of high oil prices
One of the most probable explanations for the Copom's decision to increase the Selic by such an elevated rate is the high price of crude oil in the international markets. This year alone the price of crude has swollen by over 60%. On 20 October the price of a barrel was being traded at US$55 in New York. The Brazilian central bank has based its calculations on the price of crude end the year at US$35 a barrel or below.

High oil prices prompted the state-owned Brazilian oil giant Petrobrás to increase the price of fuel by an average of 10.7% last June. Just before the Copom's October meeting, Petrobrás announced its second readjustment of the year. In the company's refineries the price of gasoline increased 2.4% and that of diesel by 4.8%. Analysts, though, were surprised by Petrobrás's new prices: previous forecasts pointed to at least a 10% increase in the price of gasoline and 12% in the price of diesel. Even with the new increase the prices charged by Petrobrás are still on average 26% lower than the prices charged abroad. 

Low readjustment fed speculation that the discrepancy in fuel prices was caused by the proximity of the run-off municipal elections in 31 October but the government has since denied it is holding the prices of fuel artificially. Finance Minister Antonio Palocci however, signaled new readjustments were on the way, a comment that might have influenced the Copom's decision to increase the Selic in order to cushion the impact of higher fuel prices on the central bank's inflation target for next year. 

The Copom's autonomy
The second explanation for the Copom's 50 basis point increase in the Selic is tactical. According to some market analysts the committee decided to go for a full-on increase in order to 'reaffirm its autonomy' in the management of Brazil's monetary policy, sending a clear message its decisions are not forced upon it by pressure from the manufacturing sectors or by the government. 

After the announcement of the impending basic interest rate increase, a wave of criticism followed. Allied and opposition congressmen called the Copom's measure 'conservative and exaggerated' and said that it would generate a 'climate of pessimism' in the country. The Central Unica dos Trabalhadores, Brazil's biggest trade union and an ally of the government, said the Copom's decision was 'in disregard with the expectations of all sectors of Brazilian society', while João Paulo Gonçalves, president of Força Sindical, declared it only proved that 'the government [had] lost control of the economic levers'.

Industry representatives also condemned the central bank's monetary committee. The National Industries' Confederation called the austerity measures 'unfavorable to investments and to the recovery of economic activity'. Most financial institutions were also surprised by the level of readjustment. According to Alex Agostini, from Global Invest, the Selic increase was 'unnecessary and shocking' in the current economic scenario. The chief-economist of Citibank in Brazil, Carlos Kawall, said the Copom's decision served to strengthen the autonomous position adopted by the central bank.

The government's position
The government was putting on a brave face after the announcement. Since July, when the first rumors of a Selic increase started to emerge, the government has tried to cool off the atmosphere by saying the country was 'suffering from an unnecessary pre-Copom tension' which was harming the economy.

President Lula da Silva has tried never to criticize the central bank's monetary policy directly, yet he made it clear on several occasions he would like to see lower interest rates. After the announcement, President Lula da Silva gave contradicting declarations: on 21 October he defended the Copom's decision, pronouncing that the committee's austere measure was necessary if the economy was to continue to recover. 'It's better to walk slowly forwards than to try bigger steps and fall at the first jump', he declared. The following day, however, Lula said consumers were being 'crushed' by high interest rates. 

Cabinet ministers also tried to minimize the impact of the Selic increase. Palocci said the committee's 'reasons [for the increase] were transparent and clear'. The minister for political coordination, Aldo Rebelo, a critic of the central bank's high interest rate policy, continued to maintain that the government's stance was to find the right 'balance between controlling inflation and reducing interest rates', but was careful not to condemn the Selic increase.

Economy and elections
The Selic increase could not have come at a worse time for the Partido dos Trabalhadores (PT), and will certainly affect the party's performance in the run-off municipal elections on 31 October. The state of the economy is fundamental to voters' support. Before economic indicators started to improve, showing that Brazil was heading for a 4% GDP growth in 2004 after having contracted 0.2% last year, a CNT-Sensus poll in June showed that 47% of Brazilians would not vote for Lula if a presidential election was held then.
The PT has only managed to attain the success it did in the first round of the municipal race on 3 October because the economy showed signs of recovery. Since then, however, several economic data releases show the economy is slowing down, mainly because of the lack of domestic demand, blamed on high interest rates. More worryingly, unemployment increased slightly to 11.4% of the workforce in September, while salaries shrunk by 0.9% year-on-year.