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Brazil's Rate Hike Harks Back to 2011, Without the Boom

Thursday, 30 May 2013 | 6:21 AM ET
Brazil Hikes Rates by 50 Basis Points
Luis Costa, EM FX strategist at Citi, tells CNBC that Brazil is stuck in a high inflation and slow growth and consumption is not growing at all.

The last time Brazil hiked interest rates by 50 basis points, in January 2011, the economy had just come off its strongest growth in 25 years with gross domestic product (GDP) rising 7.5 percent the previous year.

On Wednesday, the government reported the economy grew just 1.95 percent year-over-year in the first quarter of this year.

The numbers make Wednesday's central bank decision to hike the benchmark rate by 50 basis points to 8 percent rather more surprising.

(Read More: Forget Bank Runs, Credit Crazy Brazil Is Heading for Trouble)

In a short statement, the central bank cited the fight against inflation, which has already hit the bank's 6.5 percent target for this year as a reason for the increase. Most analysts had expected a 25 basis point hike.

"Brazil is in a very tough spot here. It's stuck in an environment of high inflation, very sticky and high inflation - so it's not collapsing such as in other emerging markets like Eastern Europe - and low growth," Luis Costa, emerging markets forex strategist at Citi told CNBC.

"The GDP numbers were extremely disappointing(...)and it showed that the important part of Brazilian GDP, which is domestic consumption is barely growing."

(Watch: 'Gloomy Picture' for Brazil: Pro)

Costa said the market was now confused after the central bank and the government spent the last year focusing more on weakening the local currency, the real, against the dollar. A weaker real was needed to boost Brazilian export competitiveness and help the economy, which slowed last year to just 0.9 percent.

"One of the main issues regarding the Brazilian government and the central bank is poor communication. If you look a year ago, eighteen months ago, they were extremely focused on the currency and now they are focused on inflation again," Costa said.

"Gradually inflation remained much stickier than what the market expected and they were forced now to focus on inflation again. So I do believe that the market is now somehow confused when it comes to what the real priority is for the government, central bank."

(Read more: Why Brazil's Once-Booming Economy Is Losing Its Shine)

Higher rates could also exacerbate another problem that Brazil's President Dilma Rouseff is trying to solve.

Economic growth in recent years has been held back by a lack of investment especially in key infrastructure such as roads, airports and ports. Brazil has an investments-to-GDP ratio of just 18 percent, much lower than other BRIC nations.

Wednesday's rate hikes could make such investments more costly.