UPDATE 3-Mexico inflation less than expected in early Jan

(Adds reaction in currency market)

By Jason Lange and Noel Randewich

MEXICO CITY, Jan 24 (Reuters) - Mexican inflation was less than expected in the first two weeks of 2008, increasing investors' bets the central bank could cut interest rates this year to protect the economy from a looming U.S. recession.

Consumer prices MXCPIF=ECI rose 0.27 percent in the first half of January, pushing 12-month inflation up 2 basis points to 3.78 percent, the central bank reported on Thursday.

Closely watched core inflation MXCPIH=ECI, which strips out some volatile food and energy prices, was 0.25 percent during the period.

"The inflation data was good, and it points to a cut," a Mexico City-based money market trader said. "The central bank has room to cut as long as inflation doesn't get worse."

Analysts in a Reuters poll ECONMX on average had predicted 0.36 percent headline inflation and 0.35 percent core inflation for the first half of the month.

After the report was released, yields fell on interest rate futures contracts for the first half of this year TII:, with the April TIIE future TIIK8 down 7 basis points to 7.84 percent.

That meant investors were betting the central bank was more likely to lower its benchmark overnight interest rate from 7.50 percent.

SPIKE EXPECTED

Mexico's central bank held its key overnight interest rate steady last week after inflation for 2007 came in within its target range of 2 percent to 4 percent.

The bank expects inflation to spike above 4 percent for much of 2008 because of stubbornly high food prices and a new tax on businesses. Until recently, some economists had been watching for a rate hike in coming months.

Mexico's central bank hiked interest rates twice last year as high food and energy prices threatened its inflation goal.

The U.S. Federal Reserve surprised markets on Tuesday by slashing interest rates in an audacious bid to thwart a U.S. recession. Since then, yields on Mexican interest rate futures have fallen steadily.

During the first two weeks of January, higher prices for electricity, housing and domestic gas drove inflation, the central bank said. Lower prices for tomatoes and vacation deals helped keep a lid on price rises.

Traders said the price data added support to the peso currency MXN= MEX01, which firmed 0.40 percent to 10.897 per dollar amid amid optimism about government and central bank efforts to boost the U.S. economy.

Inflation across Latin America has jumped as rapidly developing economies like India and China raise global demand for food commodities, while increasing amounts of grains are being diverted for use in making biofuels.

A decline in the U.S. economy would hit Mexico, which sends most of its exports to its northern neighbor. Less economic activity in Mexico would likely take pressure off inflation.

About 40 percent of economists surveyed recently by Banamex forecast a Mexican rate cut this year, up from about 15 percent in the bank's December poll. (Editing by Leslie Adler)