Russia, Brazil Mistakes Show How Inflation Can Still Arise

5:31 pm ET
May 3, 2015

Russia, Brazil Mistakes Show How Inflation Can Still Arise

• By

• MICHAEL J. CASEY/MoneyBeat

Reuters

Years of economic delusion have placed Brazil and Russia on track for a reckoning with a familiar old foe: inflation.

In 2001, both countries were named along with India and China as part of the “BRICs,” an emerging axis of new economic power famously described by former Goldman Sachs economist Jim O’Neill. Fourteen years and countless policy errors later, there is much less optimism about the BRICs, particularly in Brazil and Russia.

The latest misstep: Russia last week lowered its target repo rate by 1.5 percentage points to 12%, essentially inviting an already creeping consumer-price level to take full gallop.

Brazil, which is further along in the process of coming to grips with how damaging inflation can be if allowed to take root, announced yet another half-point increase in its Selic rate, ratcheting it up to a growth-choking 13.25%.

None of this exactly comes as a shock to those keeping score at home. Brazil has been hobbled by a nagging current-account deficit, which makes foreign debt financing vulnerable to declines in its currency.

Russia worries less about shortfalls in current-account inflows and more about capital outflows, especially from Russian citizens spooked by Western sanctions and plunging oil prices.

Russia and Brazil’s governments both must take action to inspire confidence among both local citizens and foreign investors if they are to sustain long-term economic progress. Getting short-term growth by allowing inflation to run rampant will kill that prospect.

Even as the rest of the world grapples with deflation, Brazil’s consumer price index was up 8.13% on the year in March, well above the central bank’s 6.5% maximum tolerance threshold. Ingrained inflation expectations have entrenched a self-reinforcing cycle of pre-emptive price increases.

Pump-priming policies are to blame. Brazil intervened to keep its currency weak, it maintained fiscal deficits in the face of overheated demand and state-owned banks funneled huge subsidized-interest loans to big companies with little transparency.

This unhinged economic stimulus has forced the central bank to be doubly tough in its fight against inflation. It also created distortions: Any business excluded from state largess had to borrow at rates based off the high Selic benchmark.

Now, as the unpopular President Dilma Rousseff struggles with an uncooperative Congress to rein in fiscal excess, the central bank must tighten monetary conditions even further, all while prices for Brazil’s core commodity exports are down sharply. The result: another economic contraction looms, almost four years into a period of sub-1% average growth.

“There’s nothing magic in this: They just have to walk backwards and undo everything they did over the past four years,” said Alberto Ramos, head of Latin American economics at Goldman Sachs. “It’s a multiyear adjustment, … you can’t fix things like this overnight.”

Now, Russia is making the same mistakes. Although the central bank says the rate cuts merely unwind the emergency policies introduced at year-end, it is essentially betting that short-term growth can be prioritized over inflation.

The context is that in December, when the ruble was in freefall, the repo rate was jacked up to 17% to stem the capital flight triggered by last year’s oil-price collapse and the U.S.-European sanctions over Moscow’s military engagement in Ukraine.

Now, with the Russian currency rising again as oil prices have undergone a minirecovery, both the central bank and government are saying the crisis is over, that it is time to ease rates and that the ruble should fall to restore export competitiveness. Ignored is inflation, which has risen every month since March 2014, when it was 6.9%, to 16.9% as of March 2015.

“Russia has never really cared about inflation; they just care about growth,” said Timothy Ash, head of emerging-market research at Standard Bank in London. But “the central bank is far more politicized now than it has ever been. They are basically doing what the government wants them to do.”

A more independent central bank might for once view price trends with concern. The sanctions squeeze goods supplies, increasing prices. And although the ruble has had a sharp gain this year, it is still 35% below its level 10 months ago, which makes imports expensive.

Meanwhile, soft international oil prices—which despite a 29% rebound since January are less than two-thirds their 2014 peak—are sapping profits from Russia’s vital energy industry. The result: stagflation, a state of high unemployment, weak growth and persistent inflation. It is a confidence killer for those who control Russia’s capital, and it demands tough policy measures.

President Vladimir Putin may be more resistant to weak popularity polls than Ms. Rousseff, thanks to his stranglehold on power. But he is no more able to repeal the laws of economics, a fact that will soon enough be revealed to investors who dare to tread in Russia.