SCENARIOS-Brazil struggles to fight inflation, spur economy

SAO PAULO, Feb 28 (Reuters) - Record-low interest rates, billions of dollars in tax cuts, and a more competitive exchange rate for local industries and exporters. These are the ingredients for what should be an eye-popping rebound, but Brazil's economy continues to limp along.

The government of President Dilma Rousseff is scrambling to resurrect Brazil's once-booming economy, but it wants to do so without further stoking inflation, which is already running above 6 percent annually and threatens to pierce the ceiling of the central bank's target range in coming months.

Most analysts agree there is no magic bullet for Brazil's woes, and that the road to recovery will likely be a long one. Indeed, Rousseff faces some tough economic choices this year as she gears up for a likely re-election bid in 2014.

What will Rousseff do next in her quest to get Brazil's economy back on track? Below are some options on the president's table, and the risks involved with each strategy.

TOLERATING FASTER INFLATION

This seems the most likely scenario so far, given recent remarks by policymakers.

Inflation at the end of the year is expected to remain within the government's target range and slightly below last year's rate, at 5.7 percent. But the forecast has been rising in the past few months and is dependent on optimistic assumptions about volatile food prices.

With some signs of moderation in the labor market, any attempt to rein in consumer prices may derail Brazil's fragile recovery. With a presidential election coming up in 2014, the government could ask: what is preferable, faster inflation or job losses?

At the moment, inflation is the biggest concern, but only because Brazilians feel secure in their jobs, according to a survey by Brazil's industry confederation CNI. If that changes, the tide might turn against Rousseff's re-election hopes.

The current inflation rate of 6.15 percent, as measured by the IPCA price index, is the highest in a year but small compared to the days of runaway prices and empty shelves two decades ago.

So if authorities need to choose between economic growth and higher prices, they will likely pick the first.

"Today there is no risk of inflation going out of control in Brazil," the central bank president, Alexandre Tombini, said in a speech last week.

This year's inflation dynamics could underpin such a scenario. Consumer inflation is expected to peak in the middle of the year. Without unexpected shocks, a sanguine central bank may wait for further signs of a solid economic recovery before raising interest rates.

In the meantime, one-time measures such as the recent cut in electricity rates are likely. The government has asked some local municipalities to postpone seasonal increases in bus fares and is mulling cutting taxes on food staples.

There are several risks involved, though. Public spending tends to rise in election years, which means further pressure on inflation in 2014. Also, the longer it takes for inflation to cool to the 4.5 percent target, the bigger the impact over long-term investments and the lower the central bank's credibility. The last time it hit that mark was in mid-2010.

GIVING UP ON RECORD-LOW RATES

Inflation worries could end up forcing Brazil's central bank to raise interest rates this year.

Record-low rates, championed by Rousseff as a historical shift in a country traumatized by bouts of hyperinflation, may rise by at least 100 basis points this year, according to some economists and traders.

The central bank is more likely to opt for mild hikes, though, not a full reversal of its recent cycle of 525 basis points in rate cuts. That is because the goal would be to cool inflation expectations without slowing the economy too much.

"For now, we think it is happy to continue barking louder, gaining some time and hoping for the best. Eventually, though, it will have to follow up its words with action," said BNP Paribas economist Marcelo Carvalho.

Modest rate increases might be too little to solve the mismatch between supply and demand, as pent-up spending by millions of middle-income earners continues to drive up prices of services.

A report by research firm MCM, based on the same econometric model used by the central bank, showed that a 200-basis-point hike would slash 0.8 percentage point off economic growth while only reducing 2014 inflation by 1.2 percentage points - leaving it still above the center of the government's target range.

That could prevent interest rates from falling back to 7.25 percent anytime soon, and even pave the way for further interest rate hikes, economists say.

ACCEPTING A STRONGER CURRENCY

Brazil's currency policy is at a crossroads. A 9 percent drop by the Brazilian real last year was welcomed by local manufacturers, but also fueled inflation.

The real has strengthened nearly 4 percent this year to 1.97 per dollar and remained mostly stable since the beginning of the month.

A recent Reuters poll suggested it is unlikely the government will allow further currency gains as an alternative tool to fight inflation. But that cannot be ruled out, especially if the global economy recovers at a faster pace than expected, increasing demand for Brazilian exports.

"If the currency floated freely, it would trade now at a much stronger level, around 1.80 per dollar, maybe," said Antonio Madeira, an economist with LCA Consultores in São Paulo.

However, Tombini, the central bank chief, dismissed the idea that the strengthening was part of an effort to control prices.

Also, for the government to become more tolerant of a stronger currency, industrial output would probably have to grow faster than the 3.1 percent market forecast for this year, LCA's Madeira said.

KEEPING EXPANSIONARY FISCAL POLICY

One of the reasons why inflation is high is Brazil's expansionary fiscal policy, economists say. The government failed to meet its key budget target last year, and has said it will only meet it this year by deducting some tax breaks and infrastructure investments from the calculation.

The Rousseff administration is unlikely to clamp down on budget spending as Brazil scrambles to build infrastructure for the 2014 soccer World Cup and the 2016 Olympic Games. Infrastructure, long an Achilles heel for Brazil, is one of Rousseff's top priorities.

(Reporting by Silvio Cascione; Editing by Todd Benson and Jeffrey Benkoe)