Brazil c.bank warns of extended rate-hike cycle if inflation expectations worsen

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Central bank's action crucial to steer inflation expectations back to 3% target

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Market inflation expectations remain above target despite recent rate hikes

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Fiscal measures and inflation dynamics to determine future rate hike pace

By Marcela Ayres

BRASILIA, Nov 12 (Reuters) - Brazil's central bank said on Tuesday that further deterioration in inflation expectations could extend the monetary tightening cycle, with its action remaining "a fundamental factor" in steering expectations back towards the 3% target. In the minutes from the Nov. 5-6 meeting, when policymakers accelerated the tightening pace with a 50 basis-point hike that pushed rates to 11.25%, the central bank noted that recent concerns over rising public spending and the sustainability of the country's fiscal framework have significantly impacted asset prices and market expectations. "Besides the possible need to prolong the tightening cycle ... the committee opted not to give any forward guidance on its next steps, leaving the doors wide open for further acceleration of the hiking pace," said Caio Megale, chief economist at XP.

Fiscal measures by the government and the dynamics of inflation expectations in the coming weeks will define whether the pace will be quickened, said Megale, forecasting rates to peak at 13.25%, with an upside risk.

Despite the central bank's two rate hikes since September and signals of more to come, market inflation expectations have continued to drift from the target amid a more challenging outlook for inflation, marked by a weakening Brazilian real against the U.S. dollar, stronger-than-expected economic activity, and a tight labor market.

This backdrop includes inflationary pressures fueled by policy proposals from U.S. President-elect Donald Trump and Brazil's fiscal uncertainties, which have driven up risk premiums on Latin America's largest economy. Private economists weekly surveyed by the central bank now project inflation at 4.62% this year, 4.10% in 2025 and 3.65% in 2026, in all cases above the 3% official goal, which has a 1.5 percentage point tolerance band either side.

President Luiz Inacio Lula da Silva's economic team had indicated that a package to curb mandatory spending would be presented following the conclusion of October's municipal elections. However, despite a series of meetings with ministers, the leftist leader has said he is yet to make a decision.

In the minutes, the central bank reinforced the need for sustainable fiscal rules, and said that "the reduction of spending growth, especially in a more structural way, could even induce economic growth in the medium term through its impact on financial conditions, risk premium, and better allocation of resources."

Regarding the United States, policymakers stressed continued high uncertainty around the pace of disinflation and economic slowdown, adding that potential shifts in economic policy - such as fiscal stimuli, labor supply constraints, and new import tariffs - heighten outlook doubts.

Policymakers had already reiterated in last week's decision statement their September view that the pace of future interest rate adjustments and the overall magnitude of the tightening cycle would hinge on a strong commitment to their inflation target, which they said in the minutes is "essential for the continued building of credibility."

They also raised the central bank's inflation projections further away from the target, even while factoring in a more aggressive interest rate trajectory, prompting many economists to project borrowing costs at a

higher terminal

level in the tightening cycle. (Reporting by Marcela Ayres, editing by Ed Osmond, Alexandra Hudson)