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By Alonso Soto and Luciana Otoni
BRASILIA (Reuters) - The Brazilian government's move to relax budget spending rules could undermine its own efforts to tame a surge in prices that threatens to put the brakes on growth in Latin America's largest economy.
President Dilma Rousseff's government on Monday proposed legislation that could further lower the so-called primary budget surplus target for this and next year to bolster investment. The changes allow states and municipalities to deduct public investment from their primary surplus goals - commonly known as the money set aside to pay down public debt.
But more public spending is likely to stimulate growth, making it harder for the central bank to fight inflation. Central bank policymakers on Wednesday are expected to increase interest rates from a record low 7.25 percent to bring down above-target inflation, according to a Reuters poll of economists.
"More spending, no matter what kind of spending, pressures aggregate demand and lifts inflation," said a government official who asked for anonymity to speak freely.
"On one hand the government offers tax breaks to reduce inflation, but on the other it eases fiscal policy and pushes prices higher. The government is not helping; in fact, it is making things a tad tougher for the central bank."
The official said the apparent contradiction is a result of policymakers' rush to do it all at once: bolster a feeble economic recovery while trying to keep prices in check ahead of next year's presidential election. Rousseff is expected to run for re-election.
Rousseff has tried to cap inflation by slashing electricity rates and eliminating taxes on food staples at the same time that she seeks to stimulate the economy with an avalanche of tax breaks and cheap loans to local businesses.
However, the economy remains fragile and prices are higher, signs of what analysts fear could be a new era of mediocre growth and high inflation in a country that until recently was a Wall Street darling.
High inflation has already started to hurt activity, reducing consumer spending, which has been the main driver of the Brazilian economy over the last decade. Government officials are worried that the spike in prices could ultimately curb much-needed investment and hinder economic growth.
Annual inflation sped up in March to 6.59 percent, breaching the official target ceiling of 6.5 percent for the first time since November 2011.
"If the government adopts a more expansionary fiscal policy then it loses a tool to control inflation. Monetary policy will be overloaded," said Waldemir Quadros, an expert in public accounts with the Pontifical Catholic University of Sao Paulo.
REDUCING SAVING GOALS
Monday's proposal, which was contained in the guidelines for the budget law for next year, also raised possible deductions to its overall primary surplus target of 167.4 billion reais (54.5 billion pounds) or the equivalent of 3.1 percent of the gross domestic product.
The hefty deduction, or shrinkage, in the surplus goal for next year suggests the government will keep its fiscal policy lax for some time, endangering what is considered one of the main pillars of a decade-long spell of macroeconomic stability.
The primary budget balance, which includes the accounts of the federal government, states, municipalities and state enterprises, is closely watched by investors because it measures the ability to service debt. The target represents the excess of revenue over expenditure before interest payments.
Still, Brazil's capacity to repay its debt is not compromised. Brazil's fiscal accounts look better than those of debt-stricken European nations and the United States, which have not posted primary surpluses in years.
Even if the Brazilian government cuts a hefty 85 billion reais from its primary target this year, it will still be able to lower its net public debt burden, according to a study by Sao Paulo-based consultancy LCA. Over the last decade Brazil has been able to halve its net debt to about 35 percent of GDP.
(Writing by Alonso Soto; Editing by Guillermo Parra-Bernal and Steve Orlofsky)