Brazil’s fiscal problems could derail efforts to control inflation

Brazil’s economic fundamentals remain strong. According to consensus estimates, gross domestic product (GDP) growth will surpass 3% in 2024, following strong production and exports of commodities, including oil and agricultural products. In 2025, GDP growth is expected to return to trend around 2%. Following a weak first half of the year, Brazilian equities rallied by over 6% in Q3 2024. This was mostly attributed to strong domestic activity.

Consumption has been boosted by a historically low unemployment rate, at 6.6%, and a recovery in wages which, together with the reduction in annual inflation to around 4%, contributed to an improvement in real income.

The Brazilian Central Bank’s (BCB) success in reducing inflation from a peak of 12% in 2022 had prompted monetary authorities to keep the Selic rate stable at 10.5% since June 2024. However, the combination of strong GDP growth, a tight labour market, rising inflation expectations, declining fiscal space, and a weakening currency drove the BCB to become more hawkish. The Monetary Policy Committee (COPOM), voted to increase interest rates by 25 basis points to 10.75% in September.

Figure 1 – Evolution of market’s inflation expectations for 2024, 2025 and 2026 (%)

Source: Central Bank of Brazil and EFGAM. Data as of 9 October 2024

The de-anchoring of inflation expectations has been a source of concern for the COPOM, which they see as a risk to their 3% inflation target (see Figure 1). Increased inflation expectations have been partly attributed to a weak Brazilian real, which has depreciated by over 13% against the US dollar year-to-date. 

In addition, the minutes from the September BCB meeting showed concerns over the sustainability of the current fiscal framework and the negative impact this could have on asset prices and expectations. The COPOM warned that a lax fiscal policy could exacerbate inflationary pressures and force the BCB to tighten monetary policy.

Fiscal consolidation at risk
Last year, Brazil’s government committed to a new fiscal framework which capped spending growth and expected a budget surplus by 2026.¹ This was to be achieved by eliminating the government’s primary deficit, excluding interest payments. Recent government measures to increase spending, going over the existing fiscal rules, could dampen confidence, reduce private investment, and increase financing costs. Markets estimate the primary deficit will reach 0.6% of GDP in 2024, down from 2.4% of GDP in 2023 (see Figure 2).

Figure 2 – Brazil fiscal deficit (% of GDP)

Source: IMF, LSEG Data & Analytics and EFGAM. Data as of 9 October 2024.

Despite the relative success reducing the primary deficit, the government has embarked on a series of short-term unconventional measures to increase revenue and generate enough fiscal space to increase spending further. The aim is to improve the image of a government with poor approval ratings by boosting social programs.²

Investors are concerned that some of these measures were reminiscent of the worsening of fiscal situation in previous governments from the Workers Party, Lula’s party. Government gross debt has increased by 7 percentage points to 78.5% of GDP since Lula took office in January 2023.³ Although analysts and the BCB agree that spending programs need to be reduced, the government is unlikely to concede as it enters an important period of regional elections.

A gradual tightening of monetary policy by the BCB, combined with the start of the rate-cutting cycle by the US Federal Reserve, should have provided some stabilisation to the Brazilian real. However, the challenge for central bank authorities will be to navigate a scenario with rising fiscal spending, which could dent confidence on the currency. The task is not easy.

Conclusion
The BCB has reacted strongly to the rise in inflation expectations, starting a rate hiking cycle. This sent a firm message to markets that, to reduce inflation to the 3% target, the central bank will need to decelerate an economy that is expected to grow above potential this year.

However, if the fiscal situation does not improve, any monetary tightening to slow an overheated economy will be less effective on inflation if investors lose confidence in the government’s ability to control spending.

¹ Brazil’s fiscal rule, in place since August 2023, includes a cap on government spending that cannot exceed 70% of any increase in revenue. The rule also stipulated that if the primary budget target is not met, then spending growth will be reduced to 50% of revenue increases as a measure to deter deviations.
² To circumvent the fiscal rule, the Ministry of Finance announced the use of a state lender, and not government funding, to boost social programs and provide a subsidy that would lower the cost of cooking gas.
³ Data from the Central Bank of Brazil, considering gross debt of the general government. https://www.bcb.gov.br/estatisticas/estatisticasfiscais