Analysis - Brazil's old inflation demons stalk Rousseff

RIO DE JANEIRO Wed May 4, 2011 7:53pm BST

Brazil's President Dilma Rousseff leads the first meeting of the Council for Economic and Social Development (CDES) since she took office, in Planalto Palace in Brasilia, April 26, 2011. REUTERS/Ueslei Marcelino

Brazil's President Dilma Rousseff leads the first meeting of the Council for Economic and Social Development (CDES) since she took office, in Planalto Palace in Brasilia, April 26, 2011.

Credit: Reuters/Ueslei Marcelino

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RIO DE JANEIRO (Reuters) - Even a bout of pneumonia couldn't stop Brazilian President Dilma Rousseff from repeating a central message of her presidency this weekend: she won't let inflation run out of control.

Rousseff's determination to speak from her sick bed on International Workers' Day illustrates how the inflation issue has evolved into the biggest danger to her young government.

Inflation is running at an annual pace of 6.44 percent, near the top of the government's target range, fuelling criticism that Rousseff is taking risks with Brazil's hard-won economic stability.

Brazil is not in danger of returning to the hyper-inflation of the early 1990s but it remains a sensitive issue and rising prices threaten to diminish support among Rousseff's working-class base, erode her reputation as a competent manager, and raise doubts among investors.

Part of the problem can be explained by high commodities prices plaguing emerging markets worldwide, as well as enviably strong demand in an economy that grew at a rapid 7.5 percent pace last year.

Yet it has been aggravated by Rousseff's inconsistent policy response -- and Brazil's own history.

Since the pragmatic leftist took office on January 1, she has repeatedly vowed not to "play around" with inflation. Her May 1 message to workers was her fourth such statement in a week.

"I won't allow, in any hypothesis, inflation to return to erode the spending power of workers," she said in a statement read out to union members at a May Day event in Sao Paulo.

For the moment, though, there are no signs that Rousseff is willing to follow up her tough talk with new measures that would tame inflation, such as deeper public spending cuts or further steps to curb consumer credit.

Such steps would also risk sacrificing the strong economic growth that has put her approval ratings near 75 percent.

As a result, Wall Street economists and ordinary Brazilians alike are beginning to question her commitment.

"I'm starting to have doubts about her ability to control this," said Roberto de Araujo, a 76-year-old retired lawyer and Rousseff voter, as he left a Rio supermarket.

On Araujo's mind, as well as that of many others, is Brazil's record of runaway prices that saw inflation hit 2,500 percent a year just two decades ago.

While nobody thinks inflation will reach even double digits this time around, labour unions and others are already calling for outsized wage increases to protect themselves -- a potential vicious circle that could put the inflation target at risk for 2012 and beyond.

"We've seen this film before. This is how it started," Araujo said.

TOUGH WORDS, LESS ACTION

Senior officials in Rousseff's government have told Reuters they are reluctant to sacrifice economic growth because of what they see as a foreign problem -- inflation caused by high prices for oil and other globally traded commodities.

"Why should we kill our economic growth because of a problem that does not originate here?" one official said on condition of anonymity. "We'll be responsible about inflation, of course ... but not dogmatic about it either."

The central bank has raised its benchmark rate three times this year, but its April move of 25 basis points fell short of expectations of a 50 basis point hike. Finance Minister Guido Mantega said last week the government wanted to moderate demand without "killing the goose" that laid the golden eggs.

The centrist opposition PSDB party, which has been struggling with internal divisions and has yet to land a serious blow on Rousseff's administration, has scented a rare chance to attack her economic stewardship.

It was a PSDB president, Fernando Henrique Cardoso, who tamed hyper-inflation in the 1990s and is widely credited for laying the groundwork for Rousseff's successful predecessor, Luiz Inacio Lula da Silva.

Lula managed an enviable combination of strong growth and low inflation during most of his eight-year presidency, but an election-year spending surge, which benefited Rousseff, helped push inflation to a six-year high for the whole of 2010.

"We will be firm in condemning the government for allowing the return of inflation, which mainly penalizes the working class," Senator Aecio Neves, the favourite to lead the centrist opposition in the next election, was reported by newspapers as telling union members in Sao Paulo on Sunday.

The poor and lower middle class, who are the main support base for Rousseff's leftist Workers' Party, always suffered most during Brazil's previous bouts with high inflation while wealthier Brazilians were better able to insulate themselves.

MISSED OPPORTUNITY

The government is missing a golden opportunity to stamp out inflation while it can, said Alberto Ramos, senior Latin American economist at Goldman Sachs in New York.

"There's no reason why Brazil can't or won't make the necessary adjustments now. The business cycle is favorable, the economy is strong, its revenue generation is strong," he said.

Rousseff's inconsistency on inflation was highlighted by her move in February to hand about $30 billion in extra funding to Brazil's national development bank shortly after cutting the same amount from the government's budget to cool the economy.

Mixed messages have given markets the impression of "wishful thinking and a lack of political conviction" that have helped fuel inflation expectations, Nomura said in a research note on Tuesday.

The government expects price pressures to cool in the coming months and fall towards the target by mid-2012 as the effect of the spike in commodity prices wears off and the economy slows to about 4.5 percent growth this year.

But the tight job market could spoil that scenario if it allows unions to win higher wage settlements in the second half of the year.

The central bank's weekly survey of full-year inflation expectations has risen for eight weeks to 6.37 percent.

Also looming large is a rise in the national mininum salary by around a whopping 14 percent at the start of next year.

The salary increase, which according to a rule set by Lula will total the 2010 annual inflation rate plus the 2009 economic growth rate, has a big knock-on effect on inflation as it is linked to social benefits such as pensions for nearly 19 million people.

Rafael Cortez, an analyst at Tendencias consultancy in Sao Paulo, said a prolonged period of high inflation would start to erode Rousseff's support and affect her reform agenda, which is already off to a slow start in Congress.

"When you have one, two or more years of high inflation then the argument could be made that Dilma can't maintain stability and this could have an election risk," he said.

(Additional reporting by Brian Winter and Jeb Blount; Editing by Kieran Murray)

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