By PEDRO HENRIQUE M. ANICETO*

The increase in the Selic rate to 10,75% reflects a monetary policy that is misaligned with the long-term needs of the Brazilian economy

The recent decision by the Monetary Policy Committee (Copom) to raise the basic interest rate (Selic) by 0,25 percentage points, from 10,5% to 10,75% per year, marks the first interest rate increase in Luiz Inácio Lula da Silva's third term and represents a turning point in the conduct of monetary policy.

The Central Bank justifies this decision based on the economic recovery, persistent inflationary pressures and the need to anchor inflationary expectations that are moving away from the target. However, when analyzing the macroeconomic context and current economic policy in more depth, it is possible to observe a disconnect between the Copom's decision and the national and international economic situation, revealing the limits of this excessively orthodox approach.

The Central Bank’s justification for the Selic rate hike is centered on the perception that the Brazilian economy is operating above its potential, evidenced by the “positive output gap,” and on concerns about inflation in services and food, which has proven resilient. In macroeconomic terms, a positive output gap occurs when the economy grows above its productive capacity without generating corresponding productivity gains, leading to inflationary pressures.

In this scenario, Copom believes that monetary policy should be tightened to prevent the economy from overheating, which would theoretically help prevent inflation from getting out of control. However, this assessment by the Central Bank appears to underestimate the side effects of rising interest rates, ignoring the nature of the factors driving Brazilian inflation and disregarding the negative impact on long-term growth.

Current inflation in Brazil cannot be attributed exclusively to demand pressures. Much of the price increase, particularly in the food and energy sectors, is related to supply shocks, such as climate crises affecting agricultural harvests and higher energy tariffs. In economies where inflation is predominantly cost-driven – known as cost-push inflation –, raising interest rates has limited effects on price control, since the factors underlying inflation are not sensitive to financing rates.

Given that a large part of Brazilian inflation is driven by exogenous and sectoral factors, raising the Selic rate imposes an unnecessary restriction on credit, discouraging consumption and productive investments, without, however, addressing the real causes of inflation.

The policy of increasing the Selic rate also imposes a significant burden on Gross Fixed Capital Formation (GFCF), one of the most dynamic components of the Gross Domestic Product (GDP). The increase in interest rates increases the cost of credit for companies, which then face greater difficulties in financing expansion, modernization and innovation projects. The reduction in productive investments directly affects the economy's ability to increase its total factor productivity (TFP), compromising long-term growth.

In an economy like Brazil's, where the infrastructure deficit and low industrial competitiveness are structural obstacles to growth, credit restrictions translate into a reduction in opportunities for industrial and technological development, exacerbating the country's dependence on primary sectors with low added value.

Rising interest rates also have adverse effects on fiscal dynamics. With the Selic rate higher, the government will see the cost of public debt increase, since most of the bonds issued by the National Treasury are indexed to the basic interest rate. In this scenario, Brazil, which already has a high public debt in relation to GDP, will see its interest burden increase, further limiting the fiscal space available for public investment policies.

In a context where public finances are under pressure from social demands, the increase in interest expenses imposes the need for cuts in other areas or greater debt, compromising fiscal balance and the government's ability to promote essential public policies. The fiscal scenario is aggravated when we take into account that Brazil has adopted a new fiscal regime that imposes limits on the growth of primary expenditures, which means that the increase in interest rates further restricts the State's investment capacity in strategic areas such as infrastructure, health and education.

From the perspective of economic agents’ expectations, the increase in the Selic rate also poses risks to the credibility of long-term monetary policy. Although the Central Bank has reiterated its commitment to bringing inflation closer to the target, the perception of fiscal risk and the increase in interest rates may fuel a dynamic of unanchoring expectations. With the increase in the Selic rate, the cost of credit increases not only for the public sector, but also for the private sector, generating a spiral in which the increase in financing costs reduces investment and, consequently, the economy’s growth potential.

At the same time, the perception that public debt is becoming unsustainable may lead to an increase in the risk premium demanded by investors, which results in higher long-term interest rates and a depreciation of the exchange rate. In this scenario, the Central Bank's attempt to control inflation by raising interest rates may become a second-order inflationary pressure factor, by causing an increase in the cost of imports and fueling new rounds of price adjustments in the productive sector.

The monetary policy adopted by Copom also appears to be out of step with the international situation. While the Federal Reserve The US Federal Reserve (Fed) is beginning a cycle of monetary easing, with interest rate cuts to mitigate the risk of a global recession, while Brazil is moving in the opposite direction, opting for a more contractionary stance. This divergence between the monetary policies of Brazil and the US could generate distortions in capital flows and exchange rates.

The reduction in interest rates in the US tends to weaken the dollar, which in theory could strengthen the real. However, the increase in the Selic rate in Brazil offsets this dynamic by attracting short-term speculative capital flows, which seek to take advantage of the interest rate differential between the two economies. The subsequent strengthening of the real hinders the competitiveness of Brazilian exports, worsening the current account deficit and creating pressure on the balance of payments.

The Central Bank's insistence on a rigid monetary policy, oblivious to the specificities of Brazilian inflation and the international context, suggests an orthodox view that prioritizes monetary stability over economic growth and social development. By adopting a contractionary stance in the face of inflationary pressures that are largely supply-side, the Central Bank is deepening the structural challenges of the Brazilian economy, such as low productivity and excessive dependence on credit.

Furthermore, the policy of raising interest rates compromises fiscal sustainability, restricts public investment capacity and exacerbates social inequalities, as credit becomes less accessible to the most vulnerable sections of the population.

In short, the increase in the Selic rate to 10,75% reflects a monetary policy that is misaligned with the long-term needs of the Brazilian economy. The strategy adopted by the Central Bank, by prioritizing inflation control through higher interest rates, ignores the adverse effects on GFCF, potential growth and fiscal sustainability. In a context of global challenges and internal pressures, Brazil needs a more flexible monetary policy that is coordinated with fiscal and industrial policies that promote inclusive growth, increased productivity and reduced inequalities.

Maintaining a high interest rate policy could have harmful effects, perpetuating a cycle of low growth and structural inflation, while short-term gains in terms of inflation control prove illusory in the face of medium- and long-term challenges.

*Pedro Henrique M. Aniceto is studying economics at the Federal University of Juiz de Fora (UFJF).

the earth is round there is thanks to our readers and supporters.
Help us keep this idea going.
CONTRIBUTE