By Jamie McGeever

ORLANDO, Fla. (Reuters) – Brazil’s central bank has put itself on the front line of the global battle against inflation, but its aggressive monetary tightening risks choking the economy.

The central bank is unlikely to achieve its target of 3.75% this year, and perhaps next year, with an annual inflation rate of 10%. It is increasing rates despite a chronically weak currency, and renewed concerns over the financial state.

The bank has few options.

The Brazilian central bank has a more strict framework than the U.S. Fed and European Central Bank, which recently blurred their inflation targeting guidelines to allow for greater policy flexibility.

The bank has an end-of-the year target with a 1.5 percent margin of error for either side. This gives it some flexibility. However, the bank is legally bound by a point forecast. Given Brazil’s past hyper-inflationary history, policymakers don’t want to lose their credibility by not meeting it.

The bank’s rate-setting panel, known as Copom, will announce its fifth consecutive rate increase on September 22. Only question remains as to whether or not the benchmark Selic will increase by 100 basis point, just like it did in August.

However, it’s a blunt instrument and the economy is getting darker.

Real interest rates, although not as negative as it seems, are among the most high among major economies.

Robin Brooks, from the International Institute of Finance, Washington, calculates that Brazil’s real rate of interest is less than 5% based upon 10-year nominal government bond yields, and 10-year breakeven inflation rates.

It is among the highest in a variety of emerging and key developed countries.

Brooks believes that using long-term inflation measures will remove current supply bottlenecks and the “noise” from recent inflation readings. It will give a better picture.

Jason Vieira from Infinity Asset Management, Sao Paulo draws a closer-term conclusion. He calculates Brazil’s real rate at 2.5% based on the difference in 12-month futures interest rates and the projected inflation for the following year.

Although it may not seem like much, he found that Brazil’s real rates are second to Turkey in terms of global inflation. It is expected to rise above 4% in the next year, according to him.

LOST DECADE

Recent swings in Brazil’s inflation, currency and interest rates have been remarkable.

Copom now commands one of the most aggressive rate-hiking periods of any G20 central banks, with inflation being the third highest of all G20 countries after Argentina and Turkey.

However, Brazil had the lowest inflation in its history in May, at 3%. The Selic reached 2.00% in March, the lowest level in the Selic’s history. Current Selic rates are 5.25%, and their terminal rates could reach 10%.

Arminio Fraga was the former central bank chief. He believes the central banks have no choice but to increase rates to stabilize credibility, strengthen the currency and combat a declining fiscal outlook.

“We’re not in a place where everything is under control,” he said to Reuters this month.

He also admitted that for many years, growth had been slow. Periods of high growth tend to be “low and volatile” and extend beyond short-term economic cycles and pandemics.

Brazil, according to the latest “FOCUS”, weekly survey by over 100 economists from the central bank of Brazil, is expected to increase its GDP by 5%. As Economy Minister Paulo Guedes repeatedly points out, this is a strong “V-shaped” recovery from the last year’s 4.1% contraction.

But the median forecast “FOCUS for next year” has fallen to 1.6% GDP growth compared with 2% just three weeks earlier. It was 2.5% in March.

Brazil is now more than half way to a lost decade. It’s 3% lower than the peak of its economy in 2014, has experienced two major recessions, and is unlikely to recover more than 2% between 2017 and 2019.

It has maintained a high level of unemployment. For most of the year it has been above 14%, with the lowest level at 10% almost six years back.

The numbers below also indicate that unemployment would rise to over 20% if labor force participation rates were at their pre-crisis level. Nearly a third (or more) of all active workers are currently unemployed.

It is unlikely that Brazil will see a significant increase in interest rates, which would either reduce the slack and strengthen its near-term growth prospects.

(By Jamie McGeever, Orlanda Fla.; Editing: Matthew Lewis