The Brazilian Real has fallen 18% in the last year, from 2 to the USD to 2.36, and the recent recovery has reversed almost completely since October.

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On wednesday, the Brazilian Central Bank raised interest rates to a whopping 10.50%, having raised rates by 325 basis points in the last year!

The move was a “continuation of the adjustment of the benchmark interest rate that began in the April 2013 meeting”, the central bank said in a short accompanying statement, giving no further explanation.

Basically, inflation has been high in Brazil, which has seen extreme hyperinflation in the early 90s, with prices rising as much as 6000% over the previous year (at some point). This is obviously not something they want to repeat, and therefore rates have been kept high to try and get inflation below the 4.5% levels that the central bank is comfortable with. In that fight, interest rates have been hiked and the concepts seemed to have worked till November.

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But the December number came in at 5.91% (wrongly marked as Jan in the chart above). This was higher than the earlier month. In November, the Brazilian central bank had used language that implied they would “slow down” the pace of interest rate hikes. But the reversal in the direction of inflation has spooked them and the 0.5% hit came about.

Look carefully – interest rates are at 10.5%, while inflation is at 6%.

You’ll note that Indian repo rate are 7.75% while our consumer price inflation is 10%. The fight against inflation will require interest rates to be MUCH higher than inflation for a long time before Inflation is brought under control.

Case in Point: The US in the 70s.

In the 70s, the US faced huge inflationary pressures after the oil price rises. The fed ignored it because they believed that an external price shock like oil price rises cannot be countered through monetary policy, but they had left the inflation for too high for too long. It took a Volcker to come in and raise rates to a tremendously high level before inflation was tamed.

From National Affairs:

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In the mid 70s when inflation first touched 12%, it came down to 6% soon, largely through market corrections, and interest rates weren’t hiked too much. And soon, inflation rose back to 13% when Volcker had to act strongly. 10 year treasuries went all the way to 15% and the economy went into a deep recession and inflation dropped to 3%.

And then again, inflation went quickly back up to 5% while Volcker raised rates again, causing a second recession, but bringing inflation rapidly under control.

The Point, for India

We should not consider minor improvements in inflation (like CPI coming down from 11% to 10%) as a reason for RBI to cut rates or to even keep rates stable. While they intend to protect the economy from a recession, it might just need a recession in order to get inflation under control.

The fact is that interest rates might need to stay very high, for a very long time in order to curb inflation. We don’t have the Brazilian history of hyperinflation, but the fear of extreme inflation is always going to be there.

In my opinion, the RBI must raise rates to much higher levels – more than 12% – and keep them there until CPI Inflation rates fall below 5% for a sustained term. If Brazil is an indicator, this is how things will be in the next few years; it’s now been nearly four years of extreme inflation and we are quite close to an inflexion point where all the growth in the economy will be due to inflation alone.

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