When I penned the song Central Bankers Dilemma in the summer of 2008, I was writing about the dilemma a central banker faces during a period of stagflation. When a central banker raises interest rates he constrains growth and when he lowers interest rates it exacerbates the inflation problem. Recently Japan and Switzerland engaged in expansionary monetary policy but not to stimulate their economy but rather to stem their currencies from appreciating more. Today central bankers have a new problem of how to deal in a world where developed countries have ultra stimulative monetary policy. When the United States keeps its overnight rate at roughly 0% it is very hard to raise interest rates without having your currency appreciate. Countries like Canada and Swtizerland whose economies have fared fairly well have had to maintain lower than normal interest rates to prevent a rapid appreciation of their currency. Canada has kept its overnight interest rate at 1% despite a reasonably robust economy. Luckily, Switzerland and Canada can do this without worrying too much about inflation. Unfortunately for some developing countries that is not the case.

In Brazil, interest rates are already extremely high – the overnight rate is roughly 12%. However, even despite the high interest rates, growth and inflation are both above trend. In Brazil’s case it would seem obvious that they should raise interest rates even more to cool off inflation and growth. However, in a world where other countries have nearly 0% interest rates, further moves to tighten monetary policy will make the Real even stronger. Since December the Real has already gained 10% on the dollar and has already made it very difficult for exporters. From a personal level, it is clear to me that the Real is already overvalued when I travel to countries like Argentina and the same things cost less than half the price. This marked difference is especially difficult to understand when Argentina is actually a more developed country than Brazil (based on GDP per Capita).

So the Central bankers dilemma for developing countries like Brazil is whether to raise interest rates and risk a further appreciation in the currency or to lower interest rates and risk even greater inflation. Sounds like a great subject matter for a song!