UPDATE 3-Brazil opts for bold interest rate hike despite weak economy

Wed Jan 15, 2014 6:39pm EST

* Central bank increases Selic 50 bps to 10.50 pct

* Most economists expected a moderate 25 bps rate hike

* Bank signals may slow pace of hikes at next meeting

By Alonso Soto

BRASILIA, Jan 15 (Reuters) - Brazil surprised economists by maintaining an aggressive pace of interest rate hikes on Wednesday to head off a surge in inflation, even as Latin America's largest economy struggles to gain momentum.

The central bank's monetary policy committee, known as Copom, voted unanimously to raise the so-called Selic rate to 10.50 percent from 10 percent - its highest in two years. Only 14 out of 44 economists polled by Reuters expected the bank to raise rates by 50 basis points. A majority of market traders predicted the bolder rate increase, which marked the bank's seventh straight hike.

The bank slightly changed its decision statement, reiterating that the rate increase was part of an adjustment process that started in April, but added that the decision was taken at "this moment."

The phrase reinforces the bank's previous guidance that it may slow the pace of rate hikes or even end one of the world's most aggressive monetary tightening cycles, economists say.

"The bank is telegraphing that they will slow the pace to 25 bps at next meeting or even interrupt the cycle," said Alberto Ramos, head of Latin America economic research for Goldman Sachs.

Until last week, market traders and economists were convinced the central bank was going to slow reduce the size of rate hikes to avoid scuttling the economy in an election year when President Dilma Rousseff is expected to seek a second term.

A surprise surge in prices in December that took the 12-month inflation rate close to 6 percent changed the minds of many market players who believed the bank needed to send a strong signal it is serious about bringing inflation closer to the 4.5 percent center of the target range.

Since last April, the central bank has raised the Selic rate by 325 basis points, starting with a 25 basis point increase, followed by six straight hikes of 50 basis points.

The aggressive tightening cycle has so far done little to ease inflation, which has remained under pressure from a weaker local currency and heavy government spending.

Central bank president Alexandre Tombini will face another tough choice when the monetary policy committee meets next in February. An eighth straight rate hike should help drive down inflation, but the bank will be under pressure to halt the tightening cycle to avoid undermining the economy further.

"I don't even think the central bank knows for certain what it will do next," said Zeina Latif, chief economist with XP Investimentos. "Although the bank recognizes that there are limits to the rate-hiking process, it sent the right signal after inflation rose above expectations last year."

The bank has vowed to "keep an eye" on inflation, but also remained non-committal by warning that currency volatility could hamper the effects of monetary policy on inflation.

Wednesday's half-point increase means economists are likely to revise upwards their forecasts for the Selic rate by year end, possibly taking them to around 11 percent. That is well above the "single digits" Rousseff promised at the start of her term.

High inflation could be a big political liability for Rousseff this year. A rapid increase in prices has already dented domestic consumption, which is the country's main growth engine and has underpinned the president's popularity.

"FRAGILE" BRAZIL

The Brazilian economy contracted 0.5 percent in the third quarter of 2013 from the previous quarter as investment dropped sharply. Recent data points to a feeble recovery in the fourth quarter and subdued activity at the start of 2014.

Three years of subpar economic growth have increased market pessimism but not yet hurt Rousseff's popularity as unemployment remains near record lows and wages keep rising. The left-leaning economist is the clear favorite to win a second term in the general election in October, according to recent polls.

Repeated government intervention in the economy and lax fiscal policies under Rousseff have raised doubts among investors that Brazil can return to the robust growth rates of the past decade. The Brazilian economy likely grew just above 2 percent in 2013 and private economists predict it will expand even less this year.

Brazil is struggling at a time when the global economy is starting to pick up as the United States and Europe slowly emerge from a string of financial and debt crises.

Some economists have even grouped Brazil in the so-called "fragile five" economies along with India, Indonesia, South Africa and Turkey. Those countries are seen to be especially vulnerable to a sudden flight of capital resulting from the withdrawal of U.S. monetary stimulus.

What's more, Standard & Poor's has warned it may cut Brazil's debt rating this year if public finances keep deteriorating and the economy fails to pick up speed.

Despite the weak economy, inflation in Brazil has remained well above the center of the official target range of between 2.5 percent and 6.5 percent. The central bank's own forecasts put inflation above 5 percent through 2016.

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