* Sales volumes down 0.4 pct from Jan, defying all forecasts
* Retail contracts from year ago; first time since November 2003
* Surprise drop signals that high inflation curbing demand
* Market raises bets of central bank rate hike next week
By Brad Haynes and Alonso Soto
SAO PAULO/BRASILIA, April 11 (Reuters) - Retail sales in Brazil fell unexpectedly in February, shrinking from a year earlier for the first time in nearly a decade as inflation eroded consumer spending, weakening one of the few remaining drivers of Latin America's largest economy.
The surprise drop adds more pressure on the central bank to lift interest rates from record lows next week as high inflation threatens a slow-moving economy and the reelection chances of President Dilma Rousseff next year.
"(Increasing) prices slowed retail demand in February, it was very influential," said Reinaldo Pereira, an economist with government statistics agency IBGE, which stated on Thursday that retail sales volumes fell 0.4 percent in February from January . Retail sales had been expected to rise 1.2 percent, according to the median estimate of 21 economists polled by Reuters, all of whom estimated a monthly expansion.
Solid retail demand had been one of the few bright spots in a sluggish Brazilian economy, as record-low unemployment and interest rates kept families spending despite flagging investment and falling industrial production.
February's retail sales volumes also unexpectedly slipped 0.2 percent from a year earlier, its first annual contraction since November of 2003, according to the IBGE.
"This raises the urgency to fight inflation so that the economy doesn't lose one of its main engines of growth," said Luciano Rostagno, chief strategist for Brazil with WestLB in Sao Paulo.
Yields on Brazilian interest rate futures contracts surged after the retail data was released, with most investors now betting the central bank will next week lift its benchmark Selic rate to 7.50 percent from 7.25 percent. Interest-rate contracts maturing in January 2014, the most traded in the session, rose 9 basis points to 8.01 percent.
Rostagno said some traders are even starting to bet on an interest rate hike of 50 basis points when the central bank announces it interest rate decision on April 17.
Central bank chief Alexandre Tombini faces the difficult balancing act of adjusting rates to a level that eases prices but still stimulates an economy that risks a third year of lackluster growth. Brazil's economy grew 7.5 percent in 2010, then slowed to 2.7 percent in 2011 and 0.9 percent in 2012.
Annual inflation rose to 6.59 percent in March, piercing the official target ceiling for the first time in over a year and prompting calls for an immediate rate hike.
The rise in the value of everyday products like tomatoes -- which jumped 122 percent in a year -- is worrying Brazilians, many of whom have fresh memories of the years of hyperinflation of the 1990s when prices would rise by double digits in a day. No one predicts a return of that era, but consumers are typically very sensitive.