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Tax breaks for targeted industries have been among stimulus measures undertaken by the administration of Brazil’s President Dilma Rousseff.

UESLEI MARCELINO/REUTERS

Brazil's central bank slashed its 2012 economic growth forecast on Thursday but signalled that it is unlikely to keep cutting interest rates to boost the economy because inflation looks on track to rise more than initially expected.

In its quarterly inflation report, the bank predicted that the world's sixth-largest economy will expand just 1.6 per cent this year, down sharply from its previous estimate of 2.5 per cent but in line with most market forecasts.

The revision highlights President Dilma Rousseff's No. 1 challenge – restoring Brazil's economy to the glory days of the past decade, when annual growth rates above 4 per cent helped lift millions out of poverty and make the South American country a star among emerging markets.

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The Rousseff administration has prevented an even deeper slowdown by taking a flurry of stimulus measures that include tax breaks for targeted industries and a year-long rate-cutting campaign that have brought borrowing costs to an all-time low.

But the easing cycle now looks to be over, as the central bank raised its inflation forecast for this year to 5.2 per cent from 4.7 per cent.

Additional rate cuts could nudge inflation closer to the 6.5 per cent ceiling of the government's target range, a result that would provide additional fodder for critics who worry that the central bank has pushed inflation targeting to the back burner while it focuses instead on economic growth.

Fortunately for the central bank, government plans to reduce electricity rates should help ease inflation pressures in 2013, a year when economic growth could climb back above 4 per cent, according to many economists. As a result, the central bank lowered its inflation forecast for next year to 4.9 per cent from 5 per cent.

Still, both inflation estimates remain well above the center of the official target range of 4.5 per cent – plus or minus 2 percentage points.

"The bottom line is that the central bank recognizes that its policy is not helping inflation converge toward the center of the official target and that makes it more likely that the (benchmark) Selic will remain where it is now," said Mauricio Rosal, an economist with Raymond James in Sao Paulo.

While analysts expect the central bank to leave the Selic rate unchanged at 7.5 per cent at its next meeting on Oct. 10, investors are somewhat more cautious.

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Trading in Brazilian interest rate futures on Thursday implied a 50-per-cent probability that the bank will leave rates unchanged at the bank's next meeting, according to Thomson Reuters calculations. The other half is betting on a cut of 25 basis points.

Central bank director Carlos Hamilton Araujo, a voting member of the monetary policy committee, added to some analysts' perceptions that the bank is done cutting rates for now.

"The room to continue lowering rates has been reduced," Mr. Hamilton told reporters in Brasilia after the release of the inflation report. He added that any immediate efforts to bring inflation back to the centre of the target this year would have "high costs" in terms of activity.

In the report, the central bank acknowledged that the path of 12-month inflation toward the centre of the target was not linear – in other words, there will be ups and downs before the consumer price index settles around 4.5 per cent.

The bank also flagged risks to short-term inflation, saying it "contemplates relatively benign dynamics for food prices in the medium term, although price volatility of raw materials and grains constitutes a risk factor."

For more than two months, the annual inflation rate has moved upward. A rise in food prices pushed inflation up to 5.24 per cent in August, reversing a downward trend that took inflation to a near two-year low of 4.92 per cent in June.

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While the outlook for next year is better, doubts remain whether Brazil's economy can regain the momentum of years past.

Fitch Ratings, which cut its estimate for Brazil's 2012 growth to 1.5 per cent, expects the economy to grow 4.2 per cent next year. However, it said its 2013 forecast is uncertain, "given the international financial volatility and the pace at which the Brazilian economy responds to monetary and fiscal stimuli."

The central bank did not provide economic growth estimates for 2013 in its quarterly inflation report.

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