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For the third consecutive month consumer inflation in Brazil declined on a year-over-year basis according to data released today, sparking speculation that Banco Central do Brasil President Meirelles will cut rates next month. Despite the fact that inflation is still 1.25% higher than the government’s target level, the central bank is now forecasting that the target will be met by year end which, when combined with the relatively sky high Selic rate of 12.66%, leaves Meirelles with seemingly more than enough room to cut when the Bank board meets on March 10th.

The numbers for the broad IPCA show that, for the most part, price pressure seems to be cooling (interestingly, the decline in transportation costs was driven by big decreases in the cost of new and used cars, a factor which largely offset significant increases in metropolitan public transport costs). Below is a breakout for some of the major basket components in January :

{SEE CHART BELOW}

The component of primary concern remains food. Despite declining biofuel prices, food costs rose 0.68% broadly for the month while the IPCA 15 , which specifically tracks consumer inflation in major cities only, showed an increase of 0.72% M/M in January, up from 0.32% in December. This increase has been attributed to speculation that a drought in southern Brazil will curtail output this year. Agriculture Minister Reinhold Stephanes has publicly stated that grain production may drop as much as 8% in 2009 versus last year. Some of the biggest increases in the IPCA 15 food price basket were potatoes at +11.87% for the month and fruits at +2.41%. President Lula’s government has arguably made significant strides in reducing poverty; but with nearly 35 million people still living on less than 125 Reais per month (~$55) it is unlikely that the populist leadership will be willing to risk increased food costs regardless of the impact on growth. As such, Meirelles faces real limits in his ability to cut deeply.

Even with food costs still a cause for concern, we continue to be bullish on Brazil and believe that the same prudent management that proved successful in expanding the middle class while still somewhat keeping a lid on inflation during the bubble could now help domestic consumption offset cooling external demand enough to sustain positive growth levels.

We are long the Brazilian equity market via the ETF EWZ.

Andrew Barber
Director

Matthew Hedrick
Analyst