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Brazil: return of the "inflationary dragon"?

Behold the dark side of Brazil's booming economy.

Most analysts expect the Central Bank to raise interest rates later this month, which generally helps contain inflation by reducing lending and, thus, the amount of money in circulation. And Rousseff has also pledged to cut government spending, which increased 44 percent between 2008 and 2010.

Rousseff’s predecessor, Luiz Inacio Lula da Silva, boosted public spending in 2008 to help mitigate the effects of the global recession. But the spree continued unnecessarily throughout 2010 in a classic election-year ploy, said Tony Volpon, a Latin America analyst at Nomura Securities in New York City. Rousseff must now face the inflationary consequences of all that spending.

“It’s the hangover from the party the country had last year,” Volpon said.

He’s confident the president will follow through on promises of spending cuts, which also should help quell demand and keep inflation in check.

But in the meantime, he worries that inflation-fighting measures such as raising interest rates will exacerbate one of Brazil’s other chief economic problems: The Brazilian real has surged 39 percent against the dollar in the last two years, putting it in the running to be the most overvalued currency on earth.

Part of the cause is that Brazilian interest rates — among the world’s highest — attract huge quantities of foreign money from investors eager for returns many times higher than those in the United States and Europe. Raising rates again will only serve to attract more of this so-called “hot money” into an already inflated economy.

Analysts differ over which problem — inflation or an overvalued currency — poses the biggest risk. But Volpon says both have roots in the last few years of prolific government spending. And he says fiscal restraint is the key to getting the economy back on track.

“The inflation problem that Brazil is having is just the other side of the currency problem,” he said. “Brazil can’t go on this path for much longer without facing a fairly serious crisis.”