Brazil economic outlook, August 2024
Brazil’s economy seems to be in good shape, driven by tight labor markets and investments, but risks like the fiscal deficit and restrictive monetary policy remain
Brazil’s economy seems to have held up in the second quarter of 2024. Real monthly gross domestic product was up 2.1% from a year earlier in May, thanks to 2.5% growth in the services sector.1 Farming output fell 3.1% over the same period. However, on a three-month annualized basis, real GDP grew just 1.1% in May, pointing to a growth slowdown.2 At least some of the weakness may be attributed to flooding in Rio Grande do Sul. Excluding the floods, growth would likely be higher.
After all, a tight labor market and signs of rebounding business investment point to an economy that is moving in the right direction. Still, there is a serious risk of slower growth unrelated to heavy rainfall and floods. Crucially, fiscal imbalances threaten to stoke inflation and raise interest rates. The path of Brazil’s economy will be increasingly determined by the government’s ability to shore up its finances.
Good news: A strong economic foundation
The good news is that domestic demand remains strong. A tight labor market has supported consumer spending, with the unemployment rate dropping to 6.9% in May,3 the lowest reading since 2014. The labor market is showing little to no sign of cooling off either. Employment growth accelerated to a 2.9% year-over-year rate in May, up from just 0.5% growth last October.4 Private sector employment—excluding domestic workers—was up an even stronger 4.5% over the year.5 Strong demand for labor has pushed wage growth higher as well. After adjusting for inflation, average monthly earnings were up 5.6% from a year ago in May—a clear acceleration from the 3.1% reading in December 2023 (figure 1).6
Consumers have responded positively to the improvements in the labor market. For example, retail sales volumes were up 7.0% from a year ago in May.7 Spending on food, motor vehicles, and pharmaceuticals were among the fastest-growing categories. However, the downside to such a tight labor market is that it could fuel inflation.
Even with a somewhat elevated inflation rate of about 4%, productivity growth would need to be around the 5.6% mark, the rate of real wage growth. Unfortunately, year-ago productivity growth was 0% in the first quarter of 2024 and had been notably weak even prior to the pandemic.8 Without higher productivity, wage growth will need to slow. Although 5.6% labor productivity growth will be difficult to achieve, it is also unlikely to remain at 0%. Labor productivity was higher in 2014 than it was at the start of this year, suggesting that there could be some upside to productivity even if it appears to be structurally deficient.
In addition, businesses appear to be ramping up investment, which could have positive productivity effects. Fixed capital formation grew 8.3% in the six months to March, though the year-ago growth stood at a more modest 2.6%.9 Production of capital goods, an indicator of business investment demand, dropped in May due to the flooding, but the April to May average was still up 1.8% from the previous quarter and up 10.0% from a year earlier.10 Similarly, the volume of imported capital goods was weak in May, but the April to May average shows it grew 3.6% from the previous quarter and 15.4% over the previous year.11
Accelerating wage growth, combined with weak productivity growth, could spell trouble for inflation. Indeed, headline inflation accelerated to a 4.2% year-ago rate in June, up from 3.8% as recently as April.12 Part of the jump in inflation was due to the flooding. Food prices accelerated to a 4.5% YoY growth rate in June from just 0.4% in October. Core prices were also affected in May, growing an annualized 5.0% from the previous month.13 However, in June, core prices grew at an annualized 2.4%, which is below the central bank’s 3% target. Encouragingly, services inflation has been relatively benign, at less than 0.1% on a month-to-month basis in June.14 Previous months’ figures had also been relatively weak. Given that labor costs are typically a larger share of services production, it is certainly encouraging that wage growth has not yet triggered a wage-price spiral.
Bad news: Fiscal dominance
Given that year-ago core inflation was just 3.1% in June, down slightly from 3.2% in the previous month,15 one might have expected the central bank to continue cutting the policy rate, which stands at 10.5% in nominal terms. After all, using core inflation, the real policy rate was a lofty 7.4% in June (figure 2), whereas it averaged at around 4.4% in 2017 through 2019.16 As recently as March 2024, market participants expected the policy rate to drop to 9.0% by the end of this year. But a June survey shows that they now expect the rate to remain at 10.5%.17
Part of the change is that the labor market continues to tighten more than expected, which is likely inflationary. Inflation expectations, at 6.4%, for the next 12 months, are also well above the inflation target of 3%.18 For comparison, inflation expectations were below 5% at the end of 2019. However, a large concern seems to be coming from the country’s fiscal position despite the recently implemented fiscal framework. The concern is one of fiscal dominance, where rising government debt levels impede the central bank’s ability to control inflation.
The government had initially pledged to return the primary deficit, which excludes interest payments, to balance this year. But in April, it became clear that would not happen, and the government instead announced it would end the year with a 14.5 billion reais primary deficit.19 In July, that projection was nearly doubled to 28.8 billion reais, though it narrowly remains within the fiscal framework’s tolerance range.20 To achieve this larger primary deficit, the government still had to freeze another 15 billion reais of expenditures.
The inability to get the primary deficit to surplus has concerned many investors. As a result, bond yields have moved higher. The yield on 10-year treasury bonds went from 10.3% in the last week of December to over 12.0% in July.21 The rise in bond yields will push debt levels higher as long as the primary deficit continues. In addition, the value of the currency against the dollar has depreciated sharply. At the end of last year, the currency was valued at 4.84 per US dollar.22 By the first week of July, it depreciated to 5.56 per dollar, though it has since strengthened slightly to 5.49.23 A weaker currency has the potential to raise the cost of imported goods, which could stoke inflation and raise interest rates further.
Adding to market anxiety is the fact that the ruling party has sued the president of the central bank, whose term expires this year. Two other members of the board will see their terms expire this year as well, opening the door for the current administration to replace them with policymakers who may be more malleable.24 A loss of central bank independence could lower rates in the near term but would almost certainly push rates higher over the medium to long term as inflation and inflation expectations spiral out of control. The best path forward is to rein in the fiscal deficit as soon as possible, which will ease inflationary pressures and allow the central bank to continue cutting rates. That path would allow for stronger economic growth over the medium term, benefiting debt sustainability efforts.
Brazil’s economy remains in decent shape, thanks to its tight labor market and stronger business investment—but imbalances and risks remain. The central bank’s policy rate will likely continue to be overly restrictive as long as the government runs primary deficits. The economy can handle weaker government spending in the near term so that it can unleash stronger economic gains as interest rates are allowed to come down. That will not occur this year, but stronger government finances and therefore stronger economic growth could occur before the end of 2025.