US embassy cable - 04BRASILIA613

UNCLAS SECTION 01 OF 04 BRASILIA 000613 
 
SIPDIS 
 
NSC FOR DEMPSEY, CRUZ 
TREASURY FOR OASIA/SEGAL 
FED BOARD OF GOVERNORS FOR ROBATAILLE 
USDA FOR U/S PENN, FAS/FAA/TERPSTRA 
USDOC FOR 4322/ITA/IEP/WH/OLAC-SC 
SOUTHCOM FOR POLAD 
 
E.O. 12958: N/A 
TAGS: EFIN, PGOV, ECON, EINV, ETRD, PREL, SOCI, BR, Macroeconomics & Financial 
SUBJECT: LULA HANGS FISCALLY TOUGH AMID INFLATION/INTEREST- 
RATE UNEASE 
 
REFS:  (A) BRASILIA 572, (B) BRASILIA 463, (C) BRASILIA 450, 
 
(D) 03 BRASILIA 3911 
 
1.  SUMMARY:  Amidst fresh inflation nerves over the pass- 
through of world commodity and domestic wholesale price 
pressures to the Brazilian retail level, the Central Bank 
(CB) is now expected to further delay new interest-rate cuts 
this week at its monthly COPOM meeting, perhaps at April's 
also.  Analysts are accordingly already shaving their 
forecasts of GDP growth in 2004.  Brazil's inflation data 
may be disputable; its lack of growth is not; and the CB's 
alleged over-caution is being ever more intensely pilloried. 
A typical commentary branded the current CB's disconnect 
from Brazil's real economy its widest since the previous GoB 
adopted inflation-targeting in 1999.  Lula's own PT issued a 
call for "changes in economic policy" after its latest 
Executive Committee gathering on March 4.  But Lula and his 
GoB fiscal team made PT president Genoino retract, and have 
reaffirmed more unflinchingly than ever their commitment to 
fiscal austerity in general and this year's 5.5% inflation 
target in particular.  Much of the market itself now views 
the 5.5% target as unrealistic, though.  A visiting top U.S. 
risk expert opined to us that low growth, by threatening GoB 
debt sustainability, poses a bigger financial risk than 
would relaxation of the inflation target within its existing 
band (upper limit: 8.0%.)  GoB toughness in holding the 
expectations line is understandable, but is it boxing itself 
into a too-rigid economic as well as political corner?  END 
SUMMARY. 
 
2.  Some worse-than-expected new inflation statistics have 
doused remaining hopes that the Central Bank will effect at 
least a symbolic interest-rate cut at its March COPOM 
meeting this week, and left the door open to doubt as to 
whether it will do so even in April.  In particular, the 
Getulio Vargas Foundation's IGP-DI inflation index for 
February came in at 1.08%, far over the 0.6-0.8% 
expectations.  The related IGP-M index for February 
subsequently emerged as 0.66%, up from January's 0.08%. 
Prime cause:  wholesale prices, which account for 60% of the 
IGP's base calculation.  Brazil's separate Wholesale Price 
Index (IPA) rose 2.2% in February after a 1.2% rise in 
January.  The latest Brazilian Institute of Geography and 
Economics' IPCA (Broad Consumer Price Index) data also 
caused unease when released March 10.  The IPCA figure for 
February was 0.61%, down from January's 0.76%, but its 
wholesale and industrial components (cars in particular) 
were sharply up, as were administered prices. 
 
3.  NOTE:  Brazil's inflation history has made it rich in 
official price indicators.  The latter's variance is 
fuelling arguments about current trends.  The IGP-DI index 
dates back to 1944 and can thus be accused (with its 
siblings like the IGP-M) of embodying an obsolete, wartime, 
Brazilian economic model.  Being based 60% on wholesale 
prices makes it prey to the current ongoing surge in world 
commodity prices, for example.  Similarly, a recent media 
item averred that a third of the IPA wholesale index rise 
came just from world price hikes in soy oil (due to Chinese 
demand) and eggs (due to avian flu) -- the implication being 
that such events should not be allowed to sway Brazilian 
Central-Bank policy.  Brazil's broad consumer IPCA has been 
based since 1980 on purchases in nine cities by families 
with incomes of between one and forty minimum salaries; it 
is thus more directly determined than the IGP by domestic 
economic factors and interest rates.  Even so, February's 
IPCA result was bumped by an 8% jump in start-of-school-year- 
related administered prices.  Interest-rate doves argue that 
this one-time effect likewise skewed the overall current 
Brazilian trend. 
 
4.  A separate Rio consumer index depicted local retail- 
price deflation/deflation that month.  This and other signs 
of retail stability are adduced by the interest-rate doves 
as evidence that Brazil will resist pass-through of 
wholesale inflation because of consumers' crippled real 
income and purchasing power.  But CB Chairman Meirelles 
claims GDP figures show robust growth is already underway in 
industry, requiring monetary tautness to preempt 
inflationary pressures, and points out that forward-looking 
real interest rates are already at their lowest since 1994. 
Critics charge that Meirelles is fixated on rigor for its 
own sake, and that the CB will just find more pretexts 
through the year, e.g., the effects of the new COFINS tax 
regime in May and of the next round of administered price 
increases in July-August, to hold off on SELIC cuts then, 
too.  END NOTE. 
 
5.  It may prove fleeting, but this inflation/interest-rate 
news has been dismally-timed for Lula and Brazil after last 
month's final GDP figure of -0.2% for 2003 (Ref B).  Various 
financial analysts are now putting off expectations that the 
steady decline of the Central Bank's benchmark SELIC rate 
from last June's 26.5% to December's 16.5% will resume even 
in April.  Some have accordingly already shaved their GDP 
growth projections for this year from the earlier consensus 
3.5-4% zone (Ref D).  Most others say they will do so unless 
further significant SELIC cuts resume by May.  Lula himself 
recently volunteered that 2004 growth "may not be what we 
would have wished." 
 
6.  At the same time, more and more analysts are opining 
that the GoB's 5.5% inflation target for 2004 looks 
unattainable.  The behavior of Brazilian administered prices 
(telecommunications, power, etc) so far this year has 
already been discouraging.  But pessimists' main assumption 
is that domestic retail-price levels will not much longer 
resist the impact of the ongoing rise of world commodity 
prices upon Brazil's wholesale-price level. 
 
7.  Along these lines, we recently heard the global-market 
risk expert for a top U.S. financial-house deem it ill- 
advised for the GoB to keep aiming at the 5.5% target.  The 
weight of external, wholesale and administered price 
pressures means the CB will have to keep the IPCA's `free- 
price' component's increase below four percent, which would 
require a crushing CB interest-rate squeeze, in that 
expert's assessment.  He went on to opine that the GoB 
should not put inflation-target rigidity above growth 
considerations.  Brazil's future debt sustainability would 
be more damaged by puny growth in 2004 than by the GoB 
easing its inflation target upward within the existing 
official band, say, to 6.0-6.5% (the band's ceiling is 8%,) 
our visitor thought. 
 
8.  Attacks on the CB's slowness to renew cuts in the 
benchmark SELIC rate are ever more intense amongst the usual 
political and business quarters.  But they have also spread 
to include sectors and independent voices which stuck 
solidly to the CB through Lula's first year.  One 
conservative commentator has called the gap between the CB's 
view of the real economy, and that of the rest of Brazil, 
wider than at any time since the previous GoB first adopted 
inflation-targeting in early 1999. 
 
9.  Lula's own Workers' Party (PT) emitted a statement 
calling for "changes in economic policy" after its latest 
Executive Committee meeting on March 4.  Palocci reportedly 
at once complained to President Lula, and Lula in turn 
phoned PT president Genoino to read the riot act.  Genoino 
dutifully denied that the PT statement had said exactly what 
it did say.  Former Labor Minister Wagner, now the head of 
the President's Council for Economic and Social Development, 
subsequently took his own public personal swipe at Palocci. 
 
10.  At least one national newspaper has peddled the line 
that Lula's Chief-of-Staff Dirceu is stoking intra-GoB 
criticism of Palocci's policies.  Aside from electoral 
considerations, this supposedly reflects Dirceu's self- 
serving strategy to recover from the personal damage of the 
unrelated Waldomiro Diniz scandal (Ref B).  We assess these 
rumors as just the latest Dirceu/Palocci fissure-mongering 
bunk. 
 
11.  Since the PT Executive Committee protest, Lula and 
Communications Secretary Gushiken have weighed in with 
repeated, undiluted support of Palocci's and Meirelles' 
monetary/fiscal policies.  In the process, Lula has re- 
identified himself with their policies more definitively 
than ever.  During his first six months, Lula was not above 
grandstanding over interest rates, public-utility tariffs, 
and airy promises of a "growth spectacular," in ways that 
may have left his ultimate views open to doubt.  But in his 
March 11 remarks, he broke new ground in stressing the GoB's 
long-term imperative of keeping an iron fiscal/monetary 
grip.  He re-endorsed the 4.25% budget-surplus and 5.5% 
inflation-target without qualification, commenting that even 
if the inflation target were loosened to six percent, 
"people would demand seven."  He echoed Meirelles' assertion 
that Brazil has never been so close to convergence of its 
inflation target with its actual performance.  He also 
stressed Meirelles' point about the real SELIC rate, at 10% 
(forward-looking), being the lowest in a decade. 
 
COMMENT 
------- 
12.  Lula's re-affirmation of total support for his Finance 
Minister and CB Chairman is all the more compelling in the 
context.  Still without concrete growth/job results to show 
for his first fifteen months, in a local-election year (a 
likely stimulus behind the PT leadership's protest), with 
the GoB lately at a new high of political discomfort due to 
scandal, and in the face of economic statistics that might 
well be argued as an excuse for policy easing -- Lula has 
nonetheless unambiguously committed himself neither to bend 
fiscally nor to join the widening chorus of those calling on 
the Central Bank to adopt a higher inflation target for this 
year.  At this juncture, the Lula/Palocci/Meirelles trio 
appears to have become as seamless a policy unit as its 
legendary FHC/Malan/Fraga predecessor.  That said, an 
announcement of good first-quarter GDP growth figures in 
April would it enormously easier for Lula to stay the 
course. 
 
HRINAK