Brazilian Focus: Inflation Threat - WSJ

Agonizing experience in the past inflation crisis made Mr Meirelles a die-hard inflation fighter. During one of Brazil's many past bouts of high inflation, Henrique Meirelles recalls, he and his maid had a deal. On payday, she didn't have to work. That way, she could rush to the store and spend her entire month's salary before it became worthless. Mr. Meirelles is now head of Brazil's central bank, and the country's inflationary past is a big reason why he now ranks as one of the world's toughest inflation fighters. Even as the global economy slows, the Banco Central do Brasil has acted more aggressively than many of the world's central banks against inflation, raising short-term interest rates to 13%. The bank is expected to raise rates again in September. Brazil "isn't waiting and won't wait for other central banks to act and make decisions to fight inflation pressures," says Mr. Meirelles, a former president of BankBoston Corp. Mr. Meirelles (pronounced may-RELL-es) has shown before that he means business; a series of rate increases in 2005 ground economic growth to a crawl. Central bankers in developing economies face an agonizing decision in the months ahead. The global economy is slowing and commodity prices have eased, but inflation shows signs of becoming entrenched in many places. In Brazil, Mexico, India, Egypt, Indonesia and elsewhere, central banks have unleashed a wave of interest-rate increases in recent weeks. But if they keep raising rates, they could choke off economic growth, a painful consequence in countries with high poverty rates. Mr. Meirelles, a 62-year-old with a Cheshire-cat grin and a throaty laugh, is on one end of the global debate over how aggressively banks need to act. He and many economists argue that central banks let the world economy get overheated during the past few years of growth and created price pressures that will be hard to eradicate. "While each country needs to make its own decision, we can clearly see that the more central banks act decisively to control inflation, the easier the job is for everyone else," Mr. Meirelles said in an interview. But many other central banks, particularly in Asia, haven't been as tough, figuring the recent slowdown in commodity prices will help solve the inflation problem for them. "Far and away, across the globe, the central bank that's been ahead of the curve is Brazil," says Michael Gomez, co-head of emerging markets at Pacific Investment Management Co., which manages $80 billion in these countries. He calls the decision by some banks to act less forcefully to tame inflation a gamble. If it turns out to be right, it's "no harm, no foul," he says. "If you get it wrong, you're in a tough place." Central banks in developed economies also face the trade-off between growth and inflation. In places such as the United Kingdom, on the brink of recession, interest-rate cuts could be on the horizon. But the inflation problem is more acute in many developing economies. Headline and core inflation, which excludes food and energy costs, stood at 8.6% and 4.2%, respectively, in emerging economies in May, their highest levels since around the start of this decade, according to a report last month from the International Monetary Fund. By contrast, core inflation remained steady at about 1.8% in advanced economies, even as headline inflation increased to 3.5%. Wages and labor costs are accelerating in the developing world, risking new price increases. The Asian Development Bank in July warned that "failure to respond decisively to rising prices risks repeating the mistakes industrialized countries made prior to the Great Inflation of the 1970s." With few exceptions, such as Venezuela and Argentina, central bankers are mindful of this in Latin America. Brazil, Chile, Mexico, Colombia and Peru have tightened monetary policy since early July. J.P. Morgan Chase expects rates in the region to rise an additional percentage point by the end of this year to 11%, on average, after rising more than a percentage point in the past year. Latin America is the only region in the world where bank rates currently exceed inflation, according to Gray Newman, chief economist for Latin America at Morgan Stanley. If Mr. Meirelles and others in the region are now hawks on inflation, that is because it wasn't long ago that the region was losing the fight. Between 1980 and 1994, inflation averaged well over 100% a year in Brazil, hitting a peak of more than 2,000% in the early 1990s. The price increases sapped household spending power and wreaked havoc with business plans. Mr. Meirelles, who comes from Brazil's state of Goiás -- grain and cattle land -- rose through the ranks of the former BankBoston Corp. to become one of the highest-ranking foreigners at a major U.S. bank. He left in 2002 for a successful run for Brazil's Congress in his home state but resigned to take his current position. Since taking over the central bank in January 2003, he has helped steer a Brazilian economic boom in which interest rates and inflation fell to historic lows, consolidating his place as a key power broker who has the ear of the country's president, Luiz Inácio Lula da Silva, a former labor leader whose election in 2002 caused financial markets to panic. On paper, Brazil's central bank is one of the region's least independent. A branch of the finance ministry, its governors are political appointees. Half a dozen candidates turned down the central-bank job before Mr. Meirelles accepted it, according to local reports. Mr. Meirelles says that Mr. Da Silva guaranteed the bank "fully independent" decision-making and has kept the promise. Mr. Meirelles inherited interest rates of 25% and an inflation rate of 12.5%. By February 2003, he had lifted rates to 26.5% -- an unpopular step blamed for slowing Brazil's economic growth. But inflation gradually came under control, hitting its lowest rate in decades, 3.1%, in 2006. That let the bank push rates lower. Lower interest rates sparked a consumer boom. Consumer demand was expanding at a rate of 8.5% by the end of last year, faster than the country's gross domestic product, which grew just over 5% in 2007. Starting this April, Mr. Meirelles's bank took another sharp hawkish turn, saying it needed to cool fast-growing consumer demand inside Brazil. It took rates up a half-percentage point then, and has raised twice more since, in all by 1.75 percentage points. One reason to keep inflation under control: Most labor contracts and apartment leases contain inflation-adjustment clauses, based in part on food prices. Mr. Meirelles's stance has provoked pointed criticism, even within the government. Brazil's vice president, José Alencar, in early August called Mr. Meirelles's higher rates "the path of death" for Brazil's economy. Brazil's influential former finance minister, Delfim Netto, called Mr. Meirelles's policies "infantile." Some economists insist inflation in Brazil is being imported through commodities and that domestic rate increases won't alter that. In April, Guido Mantega, the current finance minister, said if one discounted the rising price of beans, the main ingredient of feijoada, Brazil's national dish, inflation was still a reasonable 4.2%. Exporters complain that higher rates drove up the value of Brazil's currency, making exports less competitive. There are signs, though, that Mr. Meirelles's strategy is paying off. Inflation expectations have eased a bit recently, according to a weekly central-bank survey of economists and market experts. The survey shows economists expect Brazil will flirt with its cap of 6.5% inflation this year. Mr. Meirelles says his goal is to get 2009's inflation figure back to 4.5%. Mr. Meirelles doesn't see much room for leniency. When there is disequilibrium between supply and demand, he says, it will be corrected in one of two ways: higher prices or higher rates. "The big advantage of using the interest rate is that you have someone in the driver's seat. When inflation is taking care of it," he says, "no one is driving."