Why do interest rates need to rise so much in Brazil? – 02/14/2023 – Bernardo Guimarães

If high interest rates are a remedy against inflation, the interest rates of recent decades seem to indicate that Brazil needs very high doses of the remedy. Does that make sense?

It actually does. In Brazil, changes in Central Bank interest rates have relatively little effect on credit. This explains, in part, why interest rates in Brazil need to rise more than in other countries to generate a given effect on demand and inflation.

The Central Bank controls the rate that the government pays on its debt (the Selic), which is the economy’s basic rate. The Selic, in turn, affects other rates in the economy. Higher interest rates make borrowing more expensive, which reduces the demand for goods in the economy. This eases the pressure on prices (decreases inflation), but also discourages production and sales.

There are, however, two peculiarities of Brazil that affect the transmission of monetary policy to the credit market. In comparison with other countries, Brazil has: 1) a much higher proportion of earmarked credit; 2) a much larger difference between the interest rates paid by people and the Central Bank’s base rate.

Targeted credit is credit that must, by law, flow to specific sectors or purposes. In general, interest rates in these modalities do not react to changes in market rates.

For example, savings yield 6.17% per year plus the TR, which reacts very little to changes in the Selic rate. Much of the resources in the savings account must be used for mortgages. These rates must not respond to changes in the Selic rate.

Something similar happens with a large part of agricultural credit.

Until recently, BNDES loan interest rates were unrelated to market rates. That changed in 2018, when the TLP was instituted. Still, these long-term interest rates are affected by many other things besides monetary policy. For example, speeches by the president that generate uncertainty about inflation in the medium term shake these rates.

The second Brazilian particularity is that the bank spread is very high. The difference between the fees charged by banks and the base rate of the economy is much greater than in most countries similar to Brazil.

For example, overdraft interest rates are close to 8% per month. Suppose the Central Bank lowers interest rates by 0.5% (per year), so that the monthly rate drops from, say, 1.08% to 1.04% per month. If individuals pay interest of 7.87% per month, what would the drop to 7.83% affect? The difference is so great that it is not even clear that this rate reacts to changes in the Selic rate.

Because of these two peculiarities, the effect of changes in the Central Bank’s interest rate on market rates is smaller in Brazil than in other countries. Empirical studies corroborate this thesis.

As a good part of the credit market is little affected by the Selic rate, the BC needs to increase interest rates further to obtain a given effect on demand (and inflation). To increase the sensitivity of market rates to BC interest rates, we need of measures that reduce bank spreads, link earmarked credit rates to the Selic rate or cut earmarked credit.

Following a similar logic, a reduction in BNDES credit (generated, for example, by cuts in subsidies) makes room for an increase in credit in the economy (that is, for a drop in market interest rates) without generating inflation. This partly explains the big drop in interest rates, without increasing inflation, that started in 2017. Or do you think it was because President Temer didn’t like the rentiers?

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