UPDATE 2-Brazil rate cut stirs inflation, political concerns

Thu Sep 1, 2011 4:33pm EDT

* Cut raises doubts over inflation, political influence

* Inflation control will require spending restraint

* Rates seen falling further in coming months (Rewrites; adds Mantega comments, details)

By Raymond Colitt and Jeb Blount

BRASILIA/SAO PAULO, Sept 1 (Reuters) - Brazil's shock interest rate cut has raised concerns that the central bank is letting its guard down on inflation and caving in to government pressure to help cushion an economic slowdown.

The hefty cut in the benchmark rate to 12 percent from 12.5 percent at the central bank's monetary policy meeting on Wednesday comes as inflation in Latin America's largest economy is running at 7.1 percent.

Some economists are now questioning the bank's commitment to pulling inflation back down to its target.

Although it cited the darkening global economic outlook, the rate cut comes as Brazilian manufacturers suffer from a strong currency and as government officials step up calls for a reduction in the country's lofty rates.

"We see this decision as setting a dangerous precedent for monetary policy in Brazil, which goes against the inflation-targeting regime that has existed for 10 years," said Tony Volpon, Latin America strategist for Nomura.

The split decision to cut rates for the first time in two years was a shock turnaround in policy in response to growing signs of a slowdown at home as the global economy flirts with crisis. Only weeks ago, many economists were expecting a sixth straight rate hike this year.

The bank's policy committee, known as Copom, said it was concerned that a sharpening slowdown in the global economy would worsen a deceleration under way in Brazil, which grew a robust -- but unsustainable -- 7.5 percent last year. It said it saw inflation risks diminishing.

"A pause might have been justified, but the idea that the world economy is going to collapse, that inflation risks are declining rapidly, that's a real surprise," said Jankiel Santos, chief economist with BES Investimentos in Sao Paulo.

All 20 economists surveyed by Reuters had expected the rate to remain steady.

Brazil's stock market rallied more than 3 percent on Thursday on hopes the cut would be followed by more and help lift the economy, while the real currency BRBY weakened about 1.5 percent against the dollar.

Some analysts said the central bank's move was a risky bet that assumed a global slowdown would help push domestic consumer prices lower and that the government would relieve demand pressures by keeping a tight grip on spending.

"The central bank has bought into a naive and innocent view of the world economy," said Alfredo Barbutti, economist at BGC Liquidez Corretora, a Sao Paulo-based brokerage.

"The cost of this is likely to be higher inflation."

MANTEGA DOVISH

In an interview with Reuters on Wednesday before the rate decision, Finance Minister Guido Mantega struck a dovish tone on inflation, saying it was already slowing to a pace consistent with the central bank's target of 4.5 percent. For details, see [ID:nN1E7800J7]

On Thursday, he denied the central bank had given in to political pressure, calling such allegations "ridiculous."

"Copom doesn't suffer from any kind of political pressure, it has autonomy. They judge conditions and make the decision," he told reporters in Brasilia.

Interest rate futures contracts dropped as much as half a percentage point on Thursday as traders bet on looser monetary policy ahead.

The yield on the January 2012 rate futures contract DIJF2, among the most highly traded on Thursday, dropped to 11.38 percent from 11.95 percent on Wednesday. It was the sharpest one-day drop for that contract since the 2008 global crisis.

The surprise cut led analysts to tear up their previous expectations for a gradual easing or no change in rates this year. Credit Suisse analysts led by Nilson Teixeira now expect the bank's benchmark rate to fall to 8.5 percent by January 2012.

The central bank's ability to cut rates further without fanning inflation depends in large part on the government making good on its commitment to maintain fiscal discipline.

The administration has sent mixed signals on that front. On Monday it hiked its primary budget surplus target for 2011 by 10 billion reais but on Wednesday it presented a 2012 budget that aims to increase spending. [ID:nN1E77U1CQ]

President Dilma Rousseff is facing growing discontent in Congress after a round of budget cuts and corruption scandals earlier this year and faces a tough challenge to maintain austerity. (Additional reporting by Brad Haynes and Peter Murphy; Writing by Stuart Grudgings; editing by Kieran Murray and Padraic Cassidy)

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