UPDATE 4-Brazil begins tightening cycle to combat fierce inflation

Wed Apr 17, 2013 9:17pm EDT

Related Topics

* Central bank raises Selic rate to 7.50 bps from 7.25 pct

* Decision was split, two of eight members voted to hold rate

* Bank's caution signals timid tightening cycle ahead

* Inflation hits economy, Rousseff's re-election chances

By Alonso Soto

BRASILIA, April 17 (Reuters) - Brazil raised interest rates for the first time in nearly two years on Wednesday, starting what is expected to be a modest tightening cycle to counter surging inflation that threatens to wreck a weak recovery in Latin America's largest economy.

The central bank hiked its benchmark Selic rate to 7.50 percent from an all-time low of 7.25 percent. The move, expected by most economists, follows growing public uproar over rapid price increases and mounting political concerns as Brazil approaches a third year of lackluster growth in the runup to the 2014 presidential election.

The decision by the bank's monetary policy committee, the first rate hike since July 2011, was not unanimous. Two of the bank's 8-member board, known as the Copom, voted to hold the rate steady.

The central bank's decision statement said that high inflation across a variety of goods and services made a monetary policy response necessary.

Still, the bank said it will remain cautious because of continuing economic uncertainty in Brazil and abroad.

"The decision brings about the perspective for a much shorter cycle than people were expecting and in slower steps," said Jankiel Santos, chief economist with Espirito Santo Investment bank in Sao Paulo.

"The bank doesn't necessarily believe that a significant deterioration has occurred that requires a strong response."

The rate hike follows price increases that pushed inflation to 6.59 percent in March, piercing the ceiling of the government's official tolerance band of 6.5 percent. The rising cost of groceries and other basics has fueled a popular uproar in a country that endured runaway inflation as recently as two decades ago.

Inflation is complicating the political outlook for President Dilma Rousseff. She is relying on economic stability, if not dramatic growth, to help propel an expected bid for re-election next year. Though Rousseff still enjoys high approval ratings, political analysts say continued price increases or any further economic volatility could erode her support.

Central bank chief Alexandre Tombini, under fire from critics who say he was lax and let prices outrun policy decisions, faces a difficult balancing act.

He quickly complied when Rousseff, after taking office in 2011, said the downturn offered an opportunity for Brazil to bring its historically high rates more in line with those of other major economies. With ten consecutive rate cuts, however, came inflation.

While hikes are needed to put a lid on price increases, Tombini must keep them at a level that can still stoke growth.

The bank's careful language and two dissident votes for a rate hold signal a timid hike cycle ahead as policymakers worry more aggressive increases in borrowing costs could derail the weak recovery, analysts said.

"We expect a short hiking cycle of no more than 100bp-150bp total (midpoint of 125bp) spread out over 3-4 Copom meetings," said Alberto Ramos, chief Latin American economist at Goldman Sachs.

In its decision statement, the bank said "the Copom notes that domestic and, principally, foreign uncertainties surround the future outlook for inflation, suggesting that monetary policy should be conducted with caution."

High inflation has already started to hit the real economy in a country where the leftist administrations of Rousseff and her predecessor, former President Luiz Inacio Lula da Silva, have succeeded because of popular social policies that helped millions of poor Brazilians get in on a decade of steady growth.

The decade-long boom fizzled in mid-2011 and a steady series of stimulus measures is now threatened by the price increases. Retail sales fell unexpectedly in February as Brazilians kept some everyday food products off their grocery lists. Officials worry that inflation could curb future investment.

The symbol of the recent woes is the tomato.

The price of the vegetable has soared more than 120 percent in value in a year and made the front page of local magazines and newspapers criticizing the government's failure to keep inflation in check. In some parts of Brazil, a kilo of tomatoes costs more than a kilo of meat.

SHORT CYCLE

Rousseff has sought to ease inflation through means besides interest rates, such as eliminating federal taxes on food staples and slashing electricity charges. She has also promised to lure billions of dollars to fix the infrastructure bottlenecks that keep production costs high in Brazil.

At the same time, though, her government has continued to spend heavily -- even relaxing fiscal rules long used to calculate budget targets. The spending, by adding to overall demand in an economy where the government plays an outsized role in everything from purchasing to credit, helps push up prices.

The central bank, then, is left with most of the battle against inflation.

Rousseff has said that any new cycle of higher rates would be less dramatic than in the past. As recently as a decade ago, a benchmark rate beyond 26 percent, the highest of any major economy, was needed to keep prices in check in Brazil.

Tombini has acknowledged that future monetary cycles will be shorter because the Brazilian economy is now less volatile. And with growth this year predicted by some economists to be as low as 2.6 percent, the bank is expected to keep rates as loose as possible to keep fostering a recovery.

The bank's last tightening cycle started in January 2011 and raised rates to 12.50 percent from 10.75 percent over seven months. Previous cycles have been more aggressive, hiking rates higher and at a faster pace.

The scope of this tightening cycle will be crucial to mold inflation expectations in coming years.

Government officials have said they worry that if high inflation expectations become entrenched, they could undermine investment in an economy that risks entering a third year of mediocre expansion. The Brazilian economy grew 0.9 percent last year - a far cry from its red hot expansion of 7.5 percent in 2010.

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