Why So High?

Since day one, Lula’s third administration has been marked by multiple clashes with Roberto Campos Neto, president of the Brazilian Central Bank. The disagreement is over the benchmark interest rate in Brazil. Lula has repeatedly urged Campos Neto to lower rates, which he argues is necessary to stimulate the economy and reduce unemployment. Higher public revenues from the resulting growth would, in turn, help fund policies aimed at reducing inequality—a key commitment of his campaign. Campos Neto, for his part, has been hostile to the idea, arguing that lowering rates would fuel inflation and undermine the credibility and autonomy of the Central Bank. Throughout the majority of Lula’s first year in year—until August 2023—the interest rate remained at 13.75 percent. Since then, bowing to pressure from both political and market forces, the policy rate was reduced to 10.5 percent, a still outstandingly high figure. Forecasters anticipate the rate to be cut to 10.25 percent by the end of this year, but no further. The inflation target is 3 percent. Should this target be met, the resultant real interest rate would be 7.25 percent—the second highest real interest rate in the world.

These clashes between Lula and Campos Neto illustrate the complex and controversial nature of interest rate setting in Brazil, a country historically beset by high inflation and unsustained growth. Interest rates are the key instrument of central bank-driven monetary policy, affecting the availability and cost of credit, the exchange rate, the level of investment, consumption, output, and, ultimately, the population’s welfare. Low interest rates are generally considered conducive to economic growth and development, as they encourage borrowing and spending, reduce the debt servicing burden, and open the space for fiscal policy. Low interest rates, however, may also entail risks, such as increasing inflationary pressures and creating asset bubbles.¹

The Central Bank’s resistance to low interest rates stems from two complementary sources. First, the Brazilian fiscal-monetary system entails a unique institutional setup, where the basic interest rate used by the Central Bank as their monetary policy instrument is the same rate that remunerates approximately 43 percent of the national debt, which consists of no-coupon short-term bonds. Because of this, when the Central Bank carries out overnight operations involving federal treasury bonds in the public securities market its interest rate targets must include a rate of return that investors consider adequate to enable the Treasury to roll over its debt. Discretionary monetary policy in Brazil, therefore, has immediate effects on fiscal policy: how much the treasury pays when its bills mature, and the cost of issuing new debt, rises and falls directly with the monetary policy rate. The risk premium on the Treasury’s debt, in turn, sets a lower threshold on monetary policy, preventing the Central Bank from reducing its policy rate beyond a certain point the Treasury considers necessary for its lenders. 

The second source of the Central Bank’s maintenance of high interest rates is tied up with the fact that domestic prices in Brazil respond only minimally to interest rate changes. In order for the Bank to have any impact at all on prices, it needs to hike interest rates to an extraordinary degree. If the transmission channels for monetary policy worked better in Brazil, monetary policy wouldn’t need to be so extreme. Making these improvements so that interest rates can come down would require fundamental institutional reform. But the latter is little discussed today, even as fights over monetary policy repeatedly feature on the front pages of newspapers.

Treasury bonds as the liquidity management tool

The Brazilian Central Bank works under an inflation-targeting regime, and the policy rate is the primary tool used to achieve this target. If inflation is expected to rise above acceptable levels, the Central Bank increases the interest rate to steer inflation back to the target. Conversely, if the rate of inflation is deemed appropriate, the Central Bank works to maintain it. This means that, regardless of the source of inflation, the Central Bank will hike interest rates to reduce economic activity, increase unemployment, and decrease workers’ bargaining power. Understanding the mechanisms for determining interest rates is somewhat more complex and requires a short detour via repurchase agreements, the market for short-term lending. 

Repurchase agreements are financial transactions where a financial institution sells (or buys) securities with the commitment to repurchase (or resell) them at a future date, prior to or equal to the maturity date of those securities. These operations are carried out between two or more financial institutions, between a financial institution and the Central Bank, or between an institution and an individual or legal entity. The securities used can be public or private, with public securities being the most common in this type of operation due to their lower risk and liquidity. In the case of repurchase agreements involving Brazilian public securities, the operations are carried out in the Special Settlement and Custody System (Selic), a clearing system managed by the Central Bank that provides immediate transfers of securities and funds—all operations are settled with their real-time values. The Central Bank Monetary Policy Committee (COPOM) meets every 45 days to set its policy rate target. In open market operations, the Central Bank acts in the Selic system to both manage liquidity in the economy and ensure that the average interest rate on public securities aligns with its policy rate target.² The federal funds rate is called the Selic rate because of this system.

The Selic system consolidated in 1979, amid a period of high inflation. At the end of the 1980s and well into 1990s, Brazil grappled with soaring inflation rates, peaking at over 80 percent per month in 1990. To continue public financing without dollarization, the Treasury began issuing a new instrument, Letras Financeiras do Tesouro (LFT), or Treasury Financing Notes. LFTs are no-coupon bonds whose yield to maturity equals the interest accumulated by the Selic rate.(These instruments are therefore known as “post-fixed” securities in Brazil.)³ In high inflation times, short-term LFTs often served as a store of value: “post-fixation” to the Selic rate granted both adjustments to inflation and liquidity assurance by the Central Bank. When price stabilization was finally achieved with the Plano Real in 1994, the Treasury continued issuing LFTs. The peculiarity of this arrangement has persisted into the twenty-first century⁴ and shaped the country’s unconventional fiscal-monetary system.⁵

Today, approximately 43 percent of the Brazilian public debt consists of LFTs and repurchase agreements, both indexed to the Selic rate. In essence, since the short-term interest rate used by the Central Bank to regulate liquidity is also the interest rate the Treasury pays on a greater share of its debt, an increase in the policy rate means a rise, too, in the value of public debt. The Central Bank directly determines the interest rate for both bank excess reserves in open market operations and the majority of public debt securities. This not only interferes with the short-term financing needs of the National Treasury, but also renders it almost impossible to extend the maturity profile of public debt. Since a significant part of the public debt pays the same interest rate as the cost of overnight lending, market participants overwhelmingly prefer short-term, post-fixed interest rate investments. Furthermore, this practice limits the potential for the Selic rate to come down adequately; since it remunerates public bonds, it must necessarily cover the risk premium associated with the National Treasury.

This is a primary reason for Brazil’s soaring interest rate, and it has another economic consequence. While rising interest rates in other countries reduce liquidity, aggregate demand, investment, and consumption, in Brazil, by contrast, higher interest rates augment financial wealth. This is due, in large part, to the fact that the value of Selic-indexed public debt will increase directly with the overnight interest rate, and such bonds are mainly held by commercial banks as reserves: raising the rate increases their liquidity. 

Ultimately, Brazil has fallen into the trap of elevated interest rates in capital markets that discourage long-term investment, as its national Treasury must constantly roll over a great portion of its debt in short-term markets at a policy rate set high enough to achieve both low inflation and capital inflow.

The roots of inefficient monetary policy in Brazil

With such a large gap between domestic and international interest rates, one might assume that the result would be an over-appreciation of the currency, a sharp contraction in aggregate demand and, consequently, very low inflation levels, or even deflation. This, however, has not occurred. In emerging economies, monetary policy transmission channels are limited by a series of constraints, reflecting a nation’s economic, political, and social characteristics. In Brazil, these channels are outstandingly ineffective. 

One relevant reason is that credit market segmentation—the high proportion of directed credit in the total credit available—significantly reduces the ability of monetary policy to influence aggregate demand and, consequently, inflation. Often subsidized by the government, directed credit does not respond to variations in the basic interest rate, limiting the effectiveness of the credit channel.

Another significant factor is the truncated term structure of interest rates. Variations in the basic interest rate do not effectively translate into variations in Brazil’s long-term rates. This limits the impact of monetary policy on long-term consumption and investment, as economic agents do not perceive changes in long-term financing conditions. 

Many prices are also rigid. In many emerging economies, a significant portion of prices—such as energy tariffs, transportation, and fuel—is managed by the government. In Brazil, these prices do not respond directly to monetary policy, limiting the effectiveness of the Selic rate in controlling inflation. Moreover, price-adjustment contracts based on past inflation for rent or wages, a common instrument to protect real incomes, potentially create inflationary inertia that distorts monetary policy effects. Finally, the country’s huge informal sector does not respond predictably to policy rates.

The broader economic structure, too, plays a crucial role. The heavy dependence on primary sectors such as agriculture and mining increases the Brazilian economy’s vulnerability to variations in international commodity prices and other external shocks that import inflation and affect foreign capital flows. High exposure of prices to global economic conditions and exchange rate volatility leaves little space for domestic monetary policy. 

Lastly, the large share of Treasury Financial Notes (LFTs) in the total public debt composition is a key contributing factor to the obstruction of monetary policy transmission mechanisms, particularly the so-called wealth effect. The wealth effect outlines how changes in interest rates can impact the market value of assets and, consequently, consumption. When interest rates rise in most markets, the value of bonds and other financial assets tends to fall, shrinking the perceived wealth of individuals, which potentially scales down consumption and leads to inflation reduction as a result of limited aggregate demand growth. This could be the case of Brazil if its public debt was issued mainly in the form, more familiar to the advanced economies, of fixed-income instruments known in Brazil as “pre-fixed” securities. However, LFTs are no-coupon bonds whose yield varies directly with the Central Bank’s policy rate. This means the way values and yields behave in Brazil is the inverse of most debt markets. Since a large component of financial assets in Brazil is immune to changes in the policy rate, the asset value transmission channel turns out to be unproductive.

A way out?

How can Brazil overcome its pathology of chronically high interest rates? One possible solution is to separate the functions of the Selic rate itself, so that it is no longer required to operate both as the Central Bank’s main policy instrument and the main capitalization rate for the public debt. This would entail separating the money market from the treasury bonds market. If this were to occur, the Central Bank’s basic rates could be used to remunerate reserves without directly carrying the risk premium from the government debt. This would allow the Central Bank to lower its policy rate without directly affecting either the market for public debt or the volume of bank reserves. Lower interbank lending rates, in turn, lower other lending rates for households and businesses, encouraging more productive and innovative investments in the real economy.

Separating the dual functions of the Selic rate, however, would first require changing the Selic market’s structure and operation. Currently, the Selic rate is determined by the supply and demand of overnight loans between banks through repurchase agreements operations, which are collateralized by treasury bonds. Changing the Selic would entail (i) drastically reducing repurchase agreements backed by LFT treasury bonds as the tool to regulate liquidity; and (ii) replacing the Selic rate as an index that remunerates part of public debt by another index not directly associated with the Central Bank’s policy rate. This is a difficult task because Selic’s benchmark role means any alternative mechanism for public debt must start by paying above the Selic rate. Such an adjustment may only be feasible in the context of low interest rates worldwide, allowing a reduction in the Selic rate. A sudden fall in the Selic that is not connected to a fall in global rates could cause the value of public debt (and bank reserves) to decrease—creating a risk of financial panic. But in a situation in which Selic is already low, investments in alternative assets could be stimulated, and space for an alternative market for public debt opened, creating an opportunity for change. Yet lowering the Selic rate is itself difficult, according to the Treasury, as finding a borrower for its debt issues usually demands an attractive interest rate. 

In a 2005 essay on Brazil’s monetary regime, Yoshiaki Nakano argued that a “deficit zero” fiscal policy is an essential prerequisite to achieving lower interest rates, as reform of public debt management depends on the credibility of financial markets.⁶ But the way in which public debt stability should be achieved is a matter of political dispute, and different strategies can lead to opposing results. An austere fiscal policy, for example, might inadvertently produce perverse macroeconomic outcomes and even foster social and economic instability. If the government engages in strong public expenditure cuts to guarantee zero deficit or a primary surplus, it can negatively impact demand and output growth. This approach risks triggering social turmoil and might even increase the government’s risk premium, thereby increasing the cost of the debt instead of reducing it. In addition, the stability of public debt is only important, for this matter, if it effectively lowers the interest rates on public bonds, thus shifting the investment dynamics by increasing the demand for riskier assets and bonds. Stability purchased at the price of economic stagnation is likely inherently destabilizing. But even if a low Selic rate could be achieved, a strong and broad political coalition would be required to support the institutional reform. This may not be so easy, given the levels of political polarization and fragmentation in Brazil. 

Lowering the interest rate in Brazil is technically achievable but will require a fundamental challenge to the status quo. This means creating a new, stable coalition among the beneficiaries of lower interest rates capable of pressuring the government to set this reform as a priority in its agenda and supporting it throughout the process. If this is not a simple or quick task, it may be an opportunity for Lula to build upon his claim to lower interest rates and push for structural changes that avoid similar constraints in the future.