WRAPUP 1-Brazil inflation falls, chance of smaller rate hike

* Brazil's IPCA inflation index falls 0.09 pct to mid-July

* Government cuts 2010 inflation to 5.2 pct from 5.5 pct

* Twelve-month inflation slows to 4.74 percent

* Yields on interest rate futures fall across the board

By Luciana Lopez and Vanessa Stelzer

SAO PAULO, July 20 (Reuters) - Brazil's government cut its inflation forecast on Tuesday after consumer prices fell unexpectedly over the last month, raising bets the central bank could opt for a smaller interest rate hike this week.

The surprise tumble in prices backs up recent data suggesting that the economy, which many had recently fretted was in danger of overheating, is slowing considerably from its booming pace of the first quarter.

Brazil's benchmark IPCA inflation index BRIPCA=ECI fell 0.09 percent in the month to mid-July, compared with a 0.19 percent gain in the month to mid-June, the government's statistics agency IBGE said on Tuesday [ID:nN20207934].

Hours later the government cut its 2010 inflation forecast to 5.2 percent from 5.5 percent, closer to its 4.5 percent inflation target [ID:nN2096299].

Brazilians suffered through hyper-inflation into the early 1990s and are not accustomed to seeing consumer prices fall.

The slowdown could mean the central bank may decide on a smaller increase in borrowing costs when it announces a new lending rate after markets close on Wednesday.

Analysts surveyed by Reuters had expected the IPCA to rise 0.05 percent, with the 17 forecasts ranging from 0.02 percent to 0.10 percent.

Most analysts still expect policy makers to hike the benchmark interest rate to 11 percent from 10.25 percent, according to a Reuters poll. But some maintaining their forecast said a smaller hike would not be a surprise.

Sixteen of 20 analysts in a Reuters poll said they saw the central bank raising the Selic rate by 75 basis points, a slight change from the 18 of 21 analysts forecasting similarly in a previous poll. The individual analysts in some cases varied between surveys. [ID:nN20216876]

Investors pared back their expectations more aggressively on Tuesday.

Yields on Brazilian interest rate futures contracts <0#DIJ:> dropped shortly after the new inflation data, as investors bet on a smaller rate hike than previously seen.

The yield on the January 2011 DIJF1 contract, the most actively traded in the early afternoon, slid to 10.98 percent from 11.05 percent.

The government belatedly increased its 2010 economic growth forecast to 6.5 percent from 5.5 percent on Tuesday, still below central bank forecasts of 7.3 percent.

Local media had reported that Finance Minister Guido Mantega expressed concern to President Luiz Inacio Lula da Silva late last week over the impact an aggressive rate hike would have on economic activity.

Other economic indicators, including June inflation, retail sales and industrial production, have also pointed to a more moderate pace of economic expansion. That has eased pressure on the central bank to raise borrowing costs to try to rein in prices.

Policy makers have so far raised the benchmark Selic rate to 10.25 percent this year from a record-low 8.75 percent, putting Brazilian interest rates among the world's highest.

RATE HIKE STILL LIKELY

A slight rise in the core inflation rate from the month before, however, supported investor expectations for a rate hike, even if smaller. Core inflation smoothes out particularly volatile prices, such as food, which can be dependent on the weather or other unpredictable factors.

The government does not release core inflation calculations in the IPCA price reports but analysts often tally those figures separately.

"Overall, the more structural elements of inflation have eased back at the margin by more than expected," Italo Lombardi of BNP Paribas wrote in a note to clients. "The three different measures of core the (central bank) monitors are running now at much lower pace."

Nevertheless, Brazil's economy remains stronger than that of many other countries.

"I think it's hard for the central bank to decide on a smaller hike, because indicators such as employment, credit and household income remain strong," said Flavia Cattan-Naslausky of RBS Securities.

But the lower prices "could be an indication that the bank could stop tightening earlier. In other words, do 75 basis points now, and then signal a drop in the pace of monetary tightening," she said.

For details on Brazilian inflation by sector and regions, please go to: here

(Additional reporting by Guillermo Parra-Bernal and James Matthews; Writing by Raymond Colitt; Editing by Andrew Hay)