The road ahead for the Brazilian economy
A comprehensive analysis of labor, inflation, fiscal and monetary policy.
Last year, I wrote a lot about Brazil, mostly about companies and industry structures, but also some economic and political dynamics. The country stands out for having high-quality companies in many sectors, with valuations in the single digits for growth names.
This year, markets are getting more interested in Brazil (EWZ is up ~23% YTD). Curiously, it happens just as the Brazilian economy is heating up and entering a local business cycle peak: inflation is rising, unemployment is low, and the trade surplus is shrinking.
Business cycles tend to be riskier in emerging economies because they are often driven by hard constraints in the economy, usually labor or exports. The range of outcomes is also wider: if well managed, a cycle can pave the way for another period of growth; if mismanaged, it can spiral into a prolonged recession. There is also the specific risk of a commodity-price-induced ‘inflationary recession’, like the one Brazil suffered between 2014-2019.
In this context, and especially last year, I read many simplistic explanations of the type: Lula is a communist, and his infinitely expansionary policies will hit a wall. Not only is this contrary to reality, but it is also lazy and unhelpful. This article intends to do better.
I start by analyzing the origins of this growth cycle in the 2020/22 commodity boom. Then, I’ll walk through the signs that the economy is heating, and how they reflect structural limitations in the workforce and exports.
Managing these constraints requires both fiscal and monetary policy. However, I argue that, because of Brazil's credit structure, restrictive monetary policy (although inevitable) tends to be either ineffective or even counterproductive. In contrast, it is fiscal policy that has to carry the weight of managing the cycle. In this realm, I show first that Brazil’s Executive has very limited fiscal discretionary power compared to other economies, with much more weight of the Legislative. Also, despite a distribution-oriented political discourse, the Brazilian government has been toward the right kind of counter-cyclical policies. This view is quite different from the more widespread but simplistic and Manichaean views, where monetary policy is contractionary and fiscal policy is expansionary.
In the final sections, I try to provide a range of short-term and long-term outcomes, along with the key data to watch in order to assess which scenario is becoming more likely. Then, I offer a thirty-thousand-foot view of how the cycle affects different industry categories (exporters, domestic, and financial).
Whether you agree with my views or not, I hope that after reading this article, you will have a more nuanced understanding of the Brazilian economy and how fiscal and monetary policy work. This will serve you well in this and future business cycles.
Other posts on Brazil
Post-pandemic growth drivers
Between 2021 and 2024, Brazil grew at more than 3% per year, in stark contrast with a previous pre-pandemic stagnation period (2014-2019). What explains this turnaround? The table below gives us an idea: it shows the growth of the main demand and supply components of GDP in both volumes and prices.
As in previous cycles, growth was originally driven by export commodity prices. Corn, sugar, and soybeans all started to rise fast in price from 2020 onwards (see price charts below). However, output volumes in agriculture and extractive industries did not start expanding significantly until 2022/23. Before that could happen, investment was needed, and that was the first component of demand to pick up in volume very strongly in 2021.
The growth and excess profits of the export sector, along with its investments, translated into higher demand for services and manufactured products. Services account for 70% of employment and total output. Therefore, when services grow, they drive job creation and boost household wages. The charts below show the total occupied population (left, in thousands) and the wage mass (occupied population * real median salary).
A larger wage mass means stronger consumption. By 2023/24, Brazil’s economic growth was mostly driven by domestic demand sources. Part of this consumption goes back to services, but another portion goes to industrial goods. Unlike services (which are non-tradable and were met internally), the extra demand for manufactured goods was largely met by imports. Manufacturing volumes remained mostly flat through most of the period, with some positive signs in 2024.
In summary, the economy experienced a profitability boost in exports, leading to more investment and output in agriculture and extractive industries. Exports remain a positive factor in GDP, but not the leading engine of the Brazilian economy. Rather, the bulk of demand growth moved to a domestic cycle around consumption. Part of that consumption is supplied within the country, and the rest from higher imports.
Growth limitations: labor and net exports
The original kick from exports was enough to put the economy on a growth path, and the reversion of commodity prices is not severe enough to drive investment down. But the economy has started to run into mid-term limitations which, if left unattended, can cause larger problems down the road. These are primarily labor supply and the trade surplus.
Labor, inflation, productivity, and demographics
As seen above, the country has brought almost 10 million more people into the workforce since 2019. This supply came from a 7pp drop in unemployment, now close to historical lows (left chart), and a 2pp increase in the occupancy rate (working population over population in working age, right chart).
As the economy grows and demands more workers, labor becomes scarcer, and the real median salary (below) starts to pick up. The real median salary is up around 15% from the unemployment highs of late 2020.
Salaries growing above the economy put pressure on inflation, investment, and the balance of payments. If firms pass down the higher labor costs, this can generate inflation. If they don’t, margins shrink and investment slows. Higher salaries also reduce the competitiveness of exports and increase the demand for imports for consumption, damaging the trade surplus.
The classical response to a heated labor market is to cool the economy, and we’ll get to that debate later, but the issues of labor and productivity also deserve longer-term considerations.
First, the only sustainable way for an economy’s population to make more money is to become more productive (emphasis on sustainable). This requires investment in physical, intangible, and human capital. But the need to save and invest conflicts with the need to consume in the present. This is an important political conflict in Brazil, as we will see in the fiscal chapter.
Second, Brazil is close to becoming an aging country. With 1.63 births per woman (below replacement since the early 2000s) and working-age population growth of just 0.3-0.5% per year, labor supply will remain a long-term constraint. This makes investment in productivity an even more pressing need.
Third, it is possible that in order to incentivize productivity growth, a relatively ‘hot’ and inflationary labor market is a requirement. When salaries are low, people have less incentive to work, and employers have less incentive to increase the productivity of workers. Further, when there’s competition for workers, the less productive occupations have more trouble finding labor, and workers have more opportunities to move to more productive jobs.
Finally, Brazil still theoretically has a lot of unoccupied or underoccupied population that can become much more productive. There are 30 million people between 18 and 60 who are not part of the labor force, plus 7 million unemployed, 5 million underemployed, and 6 million domestic service employees (who make 1/3 of the median salary). In 2023, 10 million people between 15 and 30 did not work or study (that is unproductive!). If half of that population were incorporated, the labor force would increase by 20%.
Balance of payments
The second limiting factor is the balance of payments dynamics.
As shown below, Brazil’s most productive, competitive, and exporting activities (agriculture and extractive industries) depend on volatile prices. The country has increased production of both, but the net exports have not grown much, because prices are down. In the meantime, the economy has started to demand more manufactured goods (both for consumption and investment) and services like tourism (captured under other categories below).
Brazil has maintained a positive trade balance. The current account is in deficit because of profits paid abroad, but this refers mainly to dividends and interest that are reinvested via FDI. Still, if commodity prices remain flat or decrease, and the economy continues to grow, the trade surplus will definitely shrink. When the trade surplus shrinks, the exchange rate is pressured down, feeding into inflation.
Labor, wages, and overall economic “temperature” play a key role in this balance through two possible dynamics. If inflation and salaries run hot without a currency depreciation, the country becomes less competitive abroad while demanding more foreign goods, worsening the trade balance. Eventually, this leads to depreciation. Conversely, if the currency depreciates, the balance of trade improves, but inflation accelerates, and other sources of demand weaken. A shrinking trade surplus also increases external vulnerability. If export prices fall (common in commodities) or a drought hits, the external balance can worsen sharply.
One strength factor in this respect is that the Brazilian Central Bank holds reserves for about $300 billion, compared to yearly current account deficits of $60/70 billion. If the balance worsened suddenly, the bank could hold several years of the deficit. Although still painful, this is infinitely better than facing a balance of payments crisis and having to close the capital account entirely.
The Central Bank is pushing on a string
At the end of 2024, Brazil’s inflation started to rise (left chart below), driven by labor, services, and the depreciation of the BRL (impacting food products like coffee, rice, and meat). Inflation expectations started to decouple and remain above the Central Bank’s target (4.5% upper limit).
The Central Bank had very few options but to increase rates to protect the credibility of its target. The uptick in inflation was coincidental with two events that made credibility an important issue. First, there was fear that the central government would miss its fiscal targets (it didn’t). Second, during the whole crisis, the Central Bank’s President, appointed by Bolsonaro, was replaced by Lula’s nominee (as mandated by law). People feared that after the replacement, the CB would become too dovish. Therefore, the Bank quickly returned to a very hawkish stance, raising the interest rate (right chart) from 11.25% in November 2024 (President replacement) to 14.8% in May 2025. Based on the market inflation expectations (Focus BACEN survey), Brazil’s expected inflation-adjusted interest rate now sits close to double-digits.
Although the Central Bank had no real alternative, it now faces a classic ‘pushing on a string’ problem. It is trying to cool the economy by raising rates, but with limited effect. Due to the credit market structure in Brazil, interest rate increases take a long time to impact economic activity, and may even worsen the problem, rather than help resolve it.
The first factor is that rate hikes are ineffective at reducing consumption because households are not heavily leveraged. Household debt stands at 35% of GDP (left chart below), compared to 60/70% in the US and China, and about 40/50% in the EU. In addition, 50% of that debt comes in the form of directed or earmarked credit (right chart), mostly mortgages and family rural credit, which pay much lower rates (10% nominal on average). As a result, when the CB raises rates, consumers generally do not feel it much in their disposable income, and consumption remains resilient.
The second factor is that the most leveraged agent in the Brazilian economy is the government, which cannot change its expenditures easily because of higher rates (more on this below). Further, most of the public debt is owned by households, and most savings products are indexed to the SELIC or CDI (interbank) rates. So, an increase in the interest rate tends to generate a positive income effect for households. Brazilian households own BRL 7 trillion in financial assets, against only about BRL 4 trillion in debt, so higher rates increase their net interest income in aggregate. Of course, some households have debt and others have assets, so the final effect is more nuanced.
In other words, raising interest rates can potentially stimulate consumption rather than restrain it. In fact, one could argue that the increase in interest rates is the most stimulating fiscal policy (via income transfers from the government to households).
The only agents directly and effectively affected by rates are companies, via both borrowing costs and the opportunity cost of investment. A higher real (inflation-adjusted) rate discourages investment. After all, what does the equity return need to be in an economy where the risk-free real rate is 10%?
While this mechanism can cool the economy, it is counterproductive over the long run, because Brazil needs to increase investment as a share of GDP, not reduce it. Even in the short term, the combined effect of lower investment and stronger household consumption (through the wealth effect) could end up being inflationary.
Finally, the increase in interest rates widens the rate differential with other economies, incentivizing portfolio flows into Brazil for carry trade. This has terrible consequences. If the flows are large, they can destabilize the balance of payments when they exit, particularly during an FX stress. They also increase the foreign rent burden on the economy, without providing any productive capacity additions. Finally, they appreciate the exchange rate temporarily, helping on the inflation front but damaging the external balance front.
Therefore, the Central Bank raising rates is unlikely to effectively cool the economy enough to reduce inflationary pressures. It will eventually succeed, but at a high cost, particularly for the fiscal deficit, the investment gap, the rents owed to foreigners, and the higher risk in FX.
The Central Government is slowly becoming countercyclical.
In its current position, the Brazilian economy needs to manage its constraints more carefully. The ideal scenario would be a reduction in consumption that relieves some pressure on inflation and the trade balance, combined with regulations that promote investment and bring more people into the workforce. As seen above, the Central Bank is unable to incentivize this outcome because its policy tools are limited to raising rates.
Theoretically, the central government has the best tools for the task. It can promote or cool certain sectors of the economy, or simply reduce aggregate spending during booms. However, in Brazil, two factors work against this solution: one is the speed with which fiscal spending can be adjusted, and the second is political conflicts within the governing party. Despite this, my read is that the governing party is moving in the correct direction.
Let’s begin with speed. Even before considering what the President wants, we need to understand that the Executive has little discretionary control over Brazil’s fiscal expenses. In Brazil, it is the Legislative branch that holds budgetary power. Over 90% of the federal budget is mandated by laws and constitutional reforms. Changing most of these requires a large majority (60%) in both the Senate and the House. This system’s main benefit is that it requires political consensus and avoids the pendulum of sometimes radicalized executives. The disadvantage is that it can lead to stalemates, a lack of agility, and sometimes even contradictory goals. Lula’s party (the PT) is far from dominant in Congress, holding only 9 out of 81 senators and 68 out of 513 deputies. Reaching the necessary agreements to modify any component of that 90% of the budget is therefore a hard job, and the end result ends up being much more ‘centrist’ than ‘extremist’.
Despite this, the government party still leads negotiations and proposals. So, what does the PT want? Here we need to talk about ideology and politics. One of the PT’s promises is to improve the lives of the poor and the workers. The problem is that this goal can be in short-term to mid-term contradiction with developing the country and growing the economy, because of the need to save. To invest, sometimes workers have to have lower wages. To drive people to work, sometimes, social security benefits have to be cut.
I believe the governing party understands that the most important aspect is the long-term and maintaining macro stability (helped by the influence of large capital lobbies in Brazil). However, it also knows that this priority is in tension with its electoral base. As a result, we tend to see both things happening at the same time. Rhetorically, the government (especially in the figure of Lula) can keep a more radicalized and redistribution-focused discourse. However, in practice (especially in the figure of the Finance Minister Haddad), its actions go in the correct administrative direction.
The current fiscal plan, Novo Arcabouco Fiscal (approved in 2023), reflects this approach. It mandates the government to move to increasingly large primary fiscal surpluses. This is accomplished by limiting the growth in primary expenses to 70% of the growth in the previous year’s revenues, with limits of 0.6% and 2.5% (inflation-adjusted). This is not only contractionary (since revenues grow faster than expenses during a boom) but also counter-cyclical (allowing spending to increase when the GDP falls).
Despite the new rule, markets remained uneasy about the government’s ability (and desire) to meet the plan. This led to a short panic in the second half of 2024. The government then presented additional fiscal proposals. Here we can also see that the direction is correct. Instead of cutting on much-needed infrastructure or education, the government started to limit the rate of growth of salaries (and therefore the rate of growth of pensions), and to raise the requirements to receive social security benefits.
Contrary to the belief that ‘Lula is a leftist who wants to spend into infinity,’ the governing party has made proposals that improve Brazil’s fiscal balance. Further, this is achieved with a counter-cyclical budget that is naturally contractionary during booms, and where higher employment and output translate to lower social security benefits. This is the correct direction.
Going forward
I cannot know what will happen, but I can try to propose a range of scenarios. Then, following new data as it appears, we can get more certainty about which scenarios become more likely. At the end of this section, I list a series of very good macro reports to follow the variables as they develop.
In the short term, I’m looking mostly at the effects of Central Bank policy on labor and inflation.
The best scenario would be a soft landing on the side of consumption and services, and a moderation of inflationary pressure. This will not come about via consumption per se (the Central Bank does not have leverage here) but can happen via corporate spending in services. Hopefully, the decrease does not lead to lower investment in fixed assets (or intangibles not correctly captured separately in GDP accounts). A much more worrying scenario is one where companies are tight because of higher rates, but consumers (at least the ones with savings) are doing better on the income effect of higher reference interest rates. This will pressure both inflation and the trade surplus (as demand will continue to rise while production decreases).
On the foreign front, I’m worried about an inflow of funds to carry trade. The goal of the investors would be to profit from the exceptional rate differential (10 percentage points) between OECD countries and Brazil. This will show up in the balance of payments data. This is bad for inflation (does not cool demand by propping corporate lending), bad for the trade surplus via a more appreciated FX, and introduces a lot of systemic risk, as carry funds tend to leave in droves.
Over the long term, the Central Bank cannot solve much. Brazil needs to increase productivity per worker, which is tied to a relatively tight (but not inflationary) labor market, to investment, and to government regulation. Brazil’s exceptionally high neutral rates (the CB believes they sit at 5%, inflation-adjusted) are not conducive to investment. It is probable that more state-side reform is needed, increasing the surplus, to remove pressure on long-term neutral rates. Without higher infrastructure and export-oriented investment, the country will continue to move along commodity-price cycles. Government changes will not be reflected in GDP measures but rather in legislative changes to spending priorities.
Moving to the foreign sector again, we have a wild card: commodity prices. If commodities boom, they relax the structural trade-related limitations of the Brazilian economy, and will carry demand via investment. If they bust, they can trigger a depreciating FX force, which tends to aggravate inflation, and they also carry investment down. This is what led to the 2014-2019 recession period, albeit with a much hotter economy. That is, commodities are either a choke or a breathing aid for the Brazilian economy, but they don’t really become long-term sustainable growth factors. Without becoming a commodities price forecaster, I would say we are not in a booming period, but rather relatively mild and even low in agricultural commodities, meaning the risks here are not so high.
FDI also has an outsized effect on the balance of payments, offsetting the ‘rents’ negative portion of the current account. If FDI were to increase, it would mean both more air for the BoP (financing imports of capital) and more investment. If FDI were to decrease (mostly via lower retained earnings and more demand for paying dividends out), it would trigger both FX depreciation and lower investment. This is a similar dynamic to commodities.
Key sources to follow
A few reads during the quarter are enough to have a good pulse on the above factors:
The Minutes of the Monetary Policy Committee of the Central Bank (Atas do Copom) explain macro factors and the views from the CB.
The Situation Letter from the Applied Economics Research Institute (Carta de Conjuntura - IPEA) provides a much more detailed monthly view on key areas like fiscal policy, labor dynamics, and GDP factors. The quarterly General Vision report (Visão Geral) provides less data and more analysis.
The Macro Bulletin from the FGV-IBRE (here) is a good complement to the IPEA Situation Letter, because the Institute collects many granular data points on specific industry inflation and dynamics.
Impacts on three economic sectors
Overall, the analysis above is not sufficient to forecast the impact on each industry, which would also require a bottom-up view, company by company. However, there are key takeaways for three sectors: exporters, domestic-oriented companies, and financials.
Exporters in areas such as agricultural products, meatpacking, O&G, or mineral products are not really impacted by local factors in Brazil. Their markets (customers and competitors) are abroad, and therefore, it pays more to understand China or the US, or the specific commodity, rather than Brazil. In some cases (meatpackers mostly), they do have a big domestic segment, which can be affected. In others (company-specific), they have BRL-denominated debt, which is getting very expensive.
Domestic market companies are obviously more exposed. The degree of exposure depends on bottom-up factors like whether the sector is discretionary, the quality of the company, the degree of leverage, and the income segment served. The strength of the impact will depend on how the cycle evolves. In particular, if the commodities or FX risks become a reality, then the cycle will be much longer and harder on the economy. Overall, the cycle will clearly turn negative (soft or hard landing is the unknown), and therefore, owning low-quality names might be a risky proposition.
Finally, the financial sector is the hardest to read. Bottom-up factors obviously have a role, with lower-quality credit names (neobanks, payment processors, large banks with big SME not-earmarked credit) more exposed to the credit cycle, which will probably get worse for lower-rent consumers (the ones that do take loans) and companies (especially SMEs). On the other hand, financial names are an easy-access vehicle for the carry trade, because they make a higher spread on higher rates (50% of their book is generally risk-free via the government). Therefore, the stocks might do very well in the short to mid-term. However, as seen during 2024, these names are also super exposed to a capital flight from Brazil, which triggers a BRL depreciation, and therefore melts their balance sheets and profits in hard currency.