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Insight: Brazil's Tombini - An inflation hawk, believe it or not

By Walter Brandimarte

RIO DE JANEIRO (Reuters) - Given his checkered record so far, investors could be forgiven for thinking that Brazil's quiet, bespectacled central bank chief Alexandre Tombini is a pushover on inflation.

Since Tombini took the job in early 2011, annual inflation has often hovered above 6 percent, dangerously close to the top of the bank's target range. An unexpected spurt in prices this year scared consumers, smothered the economy and contributed to a wave of massive protests against President Dilma Rousseff's government.

The price instability, particularly sensitive in a country still haunted by 2,500 percent hyperinflation in the 1990s, led to whispers among investors that Tombini was too weak to get the problem under control - or worse - that he allowed Rousseff to pressure him into a 14-month campaign of rate cuts that many say has backfired and undermined the bank's credibility.

But those who know Tombini well - a small group, given his private nature - told Reuters they see the story differently. They say the central bank chief is likely to be more hawkish than most people think, and that he will do whatever he believes necessary in the coming months to recover the confidence of consumers and investors.

They say the recent setbacks resulted not from weakness, but from a kind of betrayal by other parts of the government including the finance ministry, which had tacitly agreed to control spending so that Tombini could keep interest rates low.

Once Tombini realized the pact had been broken - too late, some critics say - the 49-year-old career government technocrat pivoted to the orthodox training he learned two decades ago at the University of Illinois. Tombini started raising interest rates at a rapid pace in April, even as the Brazilian economy remained stuck in a two-year-long rut.

"I believe Tombini realized this: 'I have no help from the fiscal sector, so I'll fulfill my mission (myself)'," said Antonio Delfim Netto, a former finance minister in the 1960s and 70s who retains significant influence with Rousseff and senior members of her economic team.

"I have no doubt he will raise interest rates as much as he sees fit to bring inflation expectations back to 4.5 percent," the midpoint of the bank's price target range, Netto said.

That will be a big task. Consumer prices rose 6.27 percent in the 12 months through July. Although economists on average forecast the annual number will come down a bit to 5.74 percent by the end of 2013, they expect little relief next year, with inflation remaining at 5.8 percent.

Next week's rate-setting meeting will reveal a lot about Tombini's strategy to try to regain the market's confidence. Most analysts expect the central bank to raise its benchmark Selic rate, now at 8.5 percent, by half a percentage point.

However, recent turmoil in Brazilian financial markets - including a 5 percent selloff in the currency in the last week - has fed some bets that Tombini and his board could be even more aggressive, and raise the Selic by 75 basis points.

Tombini declined repeated requests to be interviewed for this story. A spokesman for Finance Minister Guido Mantega declined to comment as well.

THE BOOM IS OVER

Tombini's fortunes have to some extent mirrored Brazil's abrupt fall from grace among global investors during the past two and a half years.

When Rousseff nominated him to the post in 2010, Latin America's biggest economy was in the midst of a boom that would see it grow 7.5 percent that year, seemingly cementing its reputation as a dynamo in the mold of India or China.

Tombini was seen as a discreet career technocrat at the central bank who would be a safe guardian of Brazil's financial stability, forged at great pains since the chaos of the 1990s.

While little was known about Tombini personally, apart from the fact he - like almost all Brazilians - loves soccer, his relative blandness was also seen as a plus in a country with a long history of colorful, but ineffective public figures.

Even former President Fernando Henrique Cardoso, one of the most prominent voices of Brazil's opposition, praised Rousseff's choice and remembered Tombini had been instrumental in designing an inflation-targeting plan in his own government in 1999. "I remember he helped us with a lot of problems," Cardoso said at the time.

However, it has been downhill ever since. The economy hasn't grown above 3 percent since 2010, and is now expected to expand just 2.2 percent this year and 2.5 percent in 2014.

Inflation expectations remain stubbornly above 5.5 percent for the foreseeable future, according to the average forecasts of private economists polled by the central bank.

"They did a very, very bad job since 2011 and they let inflation expectations become un-anchored. I think this has had a very negative impact on actual inflation," said Tony Volpon, head of emerging markets research for Nomura Securities.

While the slow global economy has played a role in Brazil's troubles, economists agree that many of its problems have been self-inflicted. And perhaps none of the decisions have been quite as controversial, or enshrouded in mystery, as the management of interest rates in the past two years.

THE DEAL

What is known for sure is this: Starting in August 2011, Tombini unexpectedly began slashing the Selic, taking it from 12.50 percent to a record low of 7.25 percent by October, 2012.

The rate cutting was welcomed by most people in Brazil, which despite the economic successes of the 2000s continued to have some of the world's highest interest rates, due to the legacy from the hyperinflationary years.

In speeches, Rousseff championed the lower Selic as one of her main accomplishments, vowing it would never again return to previous highs.

Where the story becomes murkier is just how the decision to cut the Selic was made, and what guarantees Tombini received from the government in return.

Many market analysts are convinced that Rousseff herself ordered Tombini to cut the Selic to record lows. Rousseff, a trained economist, has often relished making financial policy decisions since becoming president, aides say. Brazil's central bank does not enjoy formal independence, and Rousseff has the power to replace its chief if she so desires.

However, Brazilian officials including Rousseff's spokesman, Thomas Traumann, rigorously deny that the president ordered the rate cuts. They say Tombini has de facto authority to set the Selic as he sees fit.

Werner Baer, Tombini's economics professor at the University of Illinois and one of the most respected foreign experts on Brazil's economy, agrees with Netto's more nuanced narrative of how the Selic was cut.

The story: That shortly after Tombini took the job, a pact was made between the central bank and other branches of government to work together to bring down Brazil's borrowing costs to "civilized" levels.

As part of the deal, the finance ministry and other departments would curb spending to lower the burden on monetary policy, the government as a whole would push for reforms to boost investment, and the central bank would cut interest rates.

Unfortunately, only the central bank has been able to deliver its part of the bargain.

Scared by the magnitude of the economic slowdown, Finance Minister Mantega unleashed a slew of tax breaks and cheap loans to stimulate domestic consumption.

As a result, Brazil's primary surplus, or the excess government revenue before debt payments, dropped to 2.0 percent of gross domestic product in the 12 months through June. That is far less than the 2.71 percent recorded during the same period a year ago, and also below a target of 2.3 percent for the year.

Meanwhile, investment has remained stagnant at around 18 percent of GDP - one of the lowest ratios in Latin America, and well behind the 46 percent seen in China.

The result has been severe bottlenecks in the supply of goods and continued poor infrastructure, with pressure also coming from government spending: a recipe for high inflation.

A source at the finance ministry argued it is unfair to blame fiscal policy for the shortcomings of monetary policy.

While the person said he was unaware of any pact in 2011 between the finance ministry and central bank to lower interest rates, he did say there was policy coordination to ensure rates could come down, including a decision to freeze an additional 10 billion reais from the 2011 budget.

The source also said the deterioration in the primary surplus in 2012 and 2013 resulted not from overspending, but a series of tax breaks, "which have a positive impact on the economy and inflation, besides making companies more competitive."

LATE REACTION

With so little help from other parts of the government, University of Illinois' Baer said, "the only thing Tombini can do now is to raise interest rates....

"He's done remarkably well," Baer said in an interview. "He's very smart, very discreet, and he is in a very difficult situation."

The Selic has already come up 125 basis points since April. Economists expect a rate of 9.25 percent by the end of 2013, although some such as Bradesco Asset Management and Bank of Tokyo Mitsubishi bet it will reach 10 percent by year-end.

Even some of the Brazilian government's harshest critics seem to put Tombini in a category by himself, saying he seems determined to get prices under control.

Nomura's Volpon, who regularly sends out scathing e-mails about Brazil's policy mistakes, said: "I do see now the central bank willing to take expectations seriously."

Volpon's main criticism against Tombini is that he took too long to react to a clear deterioration in Brazil's fiscal policies. "The fiscal pact was broken and the central bank kept cutting rates. That was the mistake."

Marcelo Kfoury, who helped Tombini design the central bank's inflation-targeting regime before becoming the head of the economic research department of Citi Brazil, said his former colleague will not hesitate to do what is needed to control prices, keeping them within the target band.

"If there is a threat for inflation to breach the upper limit, he is 100 percent focused on inflation," Kfoury said.

(Additional reporting by Patricia Duarte in Sao Paulo and Alonso Soto in Brasilia, Editing by Brian Winter, Kieran Murray and Leslie Gevirtz)

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