Cablegate: Lula Hangs Fiscally Tough Amid Inflation/Interest-

This record is a partial extract of the original cable. The full text of the original cable is not available.




E.O. 12958: N/A


(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

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

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.

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


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