Update on Brazil: Unexpected Monetary and Fiscal Stimulus

Thursday provided investors with an excellent reminder of the importance of thinking globally—economic, political and sentiment. Wednesday night, Brazil, one of the darlings of today’s Emerging Markets ebullience, unexpectedly announced rate cuts and more government spending—giving a big boost to Brazilian equities for the day.

Brazil’s economic history, like much of South America’s, is sullied with the aftertaste of hyperinflations past. So they were quick to start tightening when the economy looked sure-footed and inflation a rising threat earlier this year. After increasing rates the previous five meetings, Brazil’s central bank (COPOM) unexpectedly reduced overnight lending rates 50 basis points to 12%. This might seem odd—we in the developed world are used to near zero short-term rates, and even long rates above 3% or 4% seem high today. But 12%—at least by historical standards—is reasonably accommodative for much of the developing world, particularly Brazil.

In a related move, President Dilma Rousseff’s administration announced a plan to increase government spending 10%—cutting its 2012 fiscal surplus target to R$114 billion (2.5% of GDP) from an expected R$128 billion. The moves fly in the face of inflation trends in the country—up 6.9% in July (again, that feels high to us in mature countries, but that’s not nearly out of control for developing ones)—and may raise questions about policymakers’ credibility should growth slow more than forecast or global inflation trends accelerate further.

But let’s not get too hasty. This issue bears watching, but at this point it’s speculation on where things are headed more than a signal, in and of itself, as to what will happen. COPOM’s moves were ostensibly predicated on the belief the “global economic outlook has worsened considerably” and a slowdown in domestic economic activity is in medias res. Rousseff’s spending increase was primarily driven by a 13.6% boost in pension outlays, which had to be raised in line with previously approved minimum wage increases. Rousseff’s spending plan also seeks to triple spending on “poverty elimination” (no word on what precisely that means, nor its probable efficacy), health and education outlays and new programs to ramp up infrastructure spending ahead of the 2014 World Cup and 2016 Olympics.

However, political motivations can’t be completely discounted either, and that’s what has folks concerned. The Rousseff administration, up until recently, preached sharp fiscal austerity. Wednesday night’s move seems to completely contradict that. Some speculate the Rouseff administration may be trying to appease legislators, many of whom recently boycotted her legislative agenda to protest spending cuts and anti-corruption policies. Populism, bread and circuses, all of that is still alive and well in politics. Will Dilma go populist and endanger more than a decade’s worth of credibility the country and its institutions have built in inflation vigilance? Ghosts of inflations past continue to haunt around every corner.

Looking forward, it’s difficult to tell how Brazil’s latest moves will eventually play out to benefit or hurt the country. Make no mistake: Brazil is still on target to run a budget surplus, and its rates are still higher than when it started the year. But for global investors, Brazil is a powerhouse of developing market growth, and this bears watching.