More Rate Hikes Likely Coming in Brazil as Inflation Overshoots Forecasts

Brazil's Central Bank is expected to raise interest rates again in the coming months as inflation continues to overshoot forecasts. The annual inflation rate in Brazil rose to 4.83% in December 2024, above the central bank's target of 3% with a tolerance margin of 1.5 percentage points either way. The central bank has already implemented two rate hikes this year, and market participants expect the policy rate to remain at 10.5% by the end of 2024.

The main factors driving inflation in Brazil are food and beverages, housing, utilities, and transportation services. Prices in these sectors have increased markedly, contributing to overall inflation. Additionally, strong wage growth, driven by a tight labor market, is another factor fueling inflation. The real wage growth was 5.6% in May 2024, outpacing productivity growth. Fiscal imbalances, with a primary deficit target of at most 0.6% of GDP, are also putting pressure on inflation. The government's inability to meet fiscal targets and the absence of structural reforms are exacerbating inflationary pressures. A weaker real exchange rate can also increase import prices, contributing to inflation.

The Central Bank of Brazil (BCB) has been proactive in addressing recent inflation overshoots. In response to the significant jump in inflation, the BCB's Monetary Policy Committee (Copom) took rapid action, increasing the Selic rate from 2% in March 2021 to 13.75% in September 2022. This tightening approach appeared to pay off, with inflation peaking at 12.13% in April 2022 and falling to 3.16% in June 2023. However, the BCB's aggressive rate hikes have had consequences. The high interest rates have increased borrowing costs for both households and businesses, potentially slowing economic growth. Additionally, the BCB's actions have contributed to a widening interest rate differential with the U.S., which could impact the real and borrowing costs of Brazilian companies abroad.

In its latest decision, the COPOM increased the Selic rate by 50 basis points to 13.75%, citing concerns about the output gap and the risk of prolonged unanchoring of inflation expectations. The COPOM also noted that the external environment remains challenging due to the turning point in the U.S. economic cycle, which raises doubts about the pace of deceleration, disinflation, and consequently the Fed's stance. The potential consequences of further rate hikes include slower economic growth, increased borrowing costs for households, a widening interest rate differential with the U.S., and the risk of prolonged unanchoring of inflation expectations.