Latin America

How do you solve a problem like Brazil?

Ipanema Beach, Brazil
Zé Martinusso | Flickr Open | Getty Images

Despite a shrinking economy, Brazil's central bank decided to hike interest rates again on Wednesday, prompting analysts to question how to solve the conundrum that is Brazil.

"The challenge for Brazil [is that] there's really a contradiction between very high inflation and very slow growth and that's been a problem for the last couple of years. It's true that the authorities are in a bit of an awkward position," Irene Mia, regional director of Latin America and the Caribbean at the Economist Intelligence Unit (EIU) told CNBC.

Mia's comments follow the Brazilian central bank's decision to raise its benchmark interest rate to 10.50 percent, the seventh consecutive rate hike as the bank tries to contain rising inflation. The rate stood at 5.9 percent in December, above the bank's mid-range target of 4.5 percent.

The majority of economists polled by Reuters expected a 25 basis points (bps) rise but the bank surprised with its latest aggressive tightening as it introduced a 50bps increase.

The decision by the bank's monetary policy committee, known as Copom, was unanimous, prompting analysts to question when the committee will stop hiking rates as the previously booming member of the BRIC economies (of Brazil, Russia, India and China) suffers.

Brazil's economy shrank 0.5 percent in the third quarter from the second quarter of 2013, according to the government statistics agency IBGE.

Outlook for Brazil is 'grim': Pro

Although the economy grew 2.2 percent from the same period from a year earlier, the figures were a far cry from the 7.5 percent growth posted in 2010 during the heady days of a consumption-led credit boom and large foreign investments.

(Read more: Forget bank runs, credit crazy Brazil is heading for trouble)

The EIU's Mia warned the outlook was "pretty grim." "We expect Brazil to grow around 2 percent this year which is really disappointing for a BRIC economy, particularly after all the hype we saw on Brazil in past years."

The grim outlook would be exacerbated by a lack of clarity facing investors too, she warned, saying that investors in Brazil's growth story had become confused over what was happening in the country. Investors have been unsettled by the government's failure to tackle much-needed reforms such as improving infrastructure and education and dealing with high labor costs. Leftist President Dilma Rouseff has dithered in the face of elections later this year, in which she hopes to be re-elected.

(Read More: Even the Carnival can't save Brazil from a slump)

"There has been a deterioration in the credibility of the macro-economic framework, in particular, in the inflation targeting which was a key for Brazil's credibility over the last few years. That's why the economy hasn't picked up and the country is still in this very awkward situation," Mia said.

Although Bill Blain, a strategist at Mint Partners, agreed that Brazil and its fellow BRIC nations India, China and Russia faced a "very, very bleak outlook" he believed that the BRICs would still attract investment, rightfully.

"These are all economies are at the very nadir of their economic performance right now and they're all suffering enormous problems in terms of economic growth and in the way they're run. But in a world that is chasing yield the whole time, these are likely to be the economies that present opportunities as they come out of this cycle and start to see a recovery," he told CNBC.

- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt.