Brazil rate hikes: Adding fuel to the fire

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Brazilian monetary officials hiked interest rates to a six-year high on Wednesday to combat inflation and stem declines in the real, but economists say the move only tips the country closer to recession.

The Comitê de Política Monetária, or Copom, – the central bank's monetary policy committee – hiked the benchmark Selic rate by 50 basis points to 12.75 percent, in line with market expectations.

The central bank's third straight rate hike aims to slow above-target inflation and bolster the Brazilian real, which fell nearly 2 percent to a 10-year low of 3 per U.S. dollar on Wednesday. Inflation figures for February, due Friday, are expected to show annual inflation increased to a fresh 10-year high of 7.54 percent, well above the government's 4.5 percent target, according to a Reuters poll.

"This [hiking rates] is a dangerous move," Kathy Lien, managing director of BK Asset Management, told CNBC shortly after the decision. "Yes, inflation is a big problem and they've been working very hard to clamp down price pressures, but by raising interest rates, they seriously risk tossing the economy into deeper recession."

Read More'No solution' to Brazil's crisis: Economist

Brazil narrowly escaped a technical recession with growth of 0.1 percent in the third quarter following two quarters of contraction.

Consequences of rate hikes

Monetary tightening is squeezing the life out of Latin America's biggest economy, according to recent data.

Consumer confidence hit all-time low last month. Weak consumption is a direct consequence of high interest rates: as individuals use more of their income on interest payments, general spending tends to drop. Meanwhile, economists continue to cut their 2015 gross domestic product (GDP) growth projections. Forecasts are for a contraction of 0.58 percent, a central bank survey on February 27 showed, down from negative 0.5 percent a week earlier - that would mark the worst result since 1990.

"Higher interest rates are the last thing the struggling economy needs," Neil Shearing, chief emerging markets economist at Capital Economics, said in a report.

Brazil's interest rates are also diverging further from those of its emerging market peers.

"As we look forward, we could be in an environment where easing from other central banks like India will drive growth rates in those countries while Brazil will lag behind because they're hitting their economy with these rate hikes," Lien said.

Despite the gloom, more tightening is still widely expected.

"The latest sell-off in the real tips the balance towards further tightening over the coming months. If the real stabilizes around 2.95 per dollar then policymakers could opt for a smaller a 25 basis-point increase to 13 percent at their next meeting. If it drops much below 3 per dollar, they could deliver another 50 basis-point increase," Shearing added.

Changing priorities

The central bank's preoccupation with its currency is inappropriate, warned Latin American economist Dev Ashish of Societe Generale.

"It's not clear if Brazil should target appreciation of the real at this stage (it's another question if this is achievable or not) even if it appears to be the easiest way to tame inflation. BRL appreciation would surely damage the scope of the manufacturing revival," he said in a note this week.

So, what can the Banco Central do Brasil do? Not much, according to Societe Generale.

"We think that fiscal and monetary policy reform will be inadequate to resolve Brazil's current problems in the absence of structural reform," Ashish said. "As a result, policy, macroeconomic and financial uncertainties are rising."