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Brazilian real coins are seen in this picture illustration taken in Rio de Janeiro October 15, 2010.


Brazil unexpectedly slashed its key interest rate, citing concern that a prolonged global slump will put the brakes on growth in Latin America's largest economy.

The move to cut rates by a half point came without warning and followed a campaign of five rate hikes aimed at battling Brazil's hot inflation rate, which has hit a six-year high of 7.1 per cent.

Even after the cut, Brazil has one of the highest interest rates in the world – a choking 12 per cent. The country's central bank has now decided high rates pose a greater risk to the economy than inflation.

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But many economists say the move appears geared more to dampening the country's red-hot currency and giving its exporters a helping hand, and raises the prospect that other countries could follow suit in a bid to keep their own currencies at bay.

"Analysts are today really mourning the death of the inflation targeting regime. Maybe what we're witnessing here is the birth of the foreign-exchange targeting regime," said Gustavo Rangel, chief Brazil economist at ING Financial Markets in New York, who believes the abrupt shift has caused the central bank to lose credibility and raises questions over its independence.

"This is a central bank that's very well regarded around the world, and the fact that it's doing this, it could pave the way for another version of these so-called currency wars. It could be another avenue for that to play out," Mr. Rangel said.

The move speaks volumes about the tightrope policy makers must walk in the world's seventh-largest economy. Rising inflation has prompted the bank to hike interest rates this year. But a hot economy and high rates have made the currency one of the world's most overvalued. Brazil's real has soared more than 40 per cent since the end of 2008, making exports less competitive and attracting a flood of cheap imports.

Officials in Brazil are worried that a slumping global economy will accelerate a recent cooling in the country's economy. After roaring ahead by 7.5 per cent last year, the economy is expected to grow between 3.7 to 4 per cent this year – still roughly twice as fast as Canada's. The cut came after economic activity slowed in June for the first time since 2008.

"Reviewing the international scenario, the monetary policy committee considers that there has been a substantial deterioration, backed ... by large and widespread reductions to the growth forecasts of the main economic regions," the Banco Central do Brasil bank said in an unusually wordy statement.

"We, in the financial markets, are very upset about the situation," said Andre Perfeito, chief economist at Gradual Investimentos in an interview from São Paulo. "I agree that our interest rates are completely insane right now ... but the central bank needs to restore reasonable communication with us."

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The move revived concern about government influence in monetary policy after a series of comments by senior officials pushing for a rate cut in recent days. Unions and manufacturers are pressing for deeper cuts.

Taking the focus off inflation is particularly controversial in a country where memories of hyper-inflation and its toll on society are still painfully fresh.

The decision wasn't unanimous – five central bank members voted in favour of the cut and two people wanted a pause – and minutes of the meeting will be published next week. The statement gave no indication of where rates are headed next.

The softening global economic outlook gave the central bank an opportunity to cut rates, but it's not the chief reason, said Oscar Sánchez, senior Latin America economist for the Bank of Nova Scotia.

"It's an excuse to lower the currency. That's the only way to understand it," he said. Demand is solid, services are strong and so are wage and credit growth. He thinks the reason may be tied to pressure from those in the large and powerful industrial base "that have the ear of the government."

The question now is whether other Latin American countries will follow suit in reducing rates. If they do, and if the rationale is tied more to currency protection than weaker inflation expectations, look for a return to the term coined by Brazil's finance minister last year to describe competitive devaluation: currency wars.

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With files from Bloomberg News and Reuters.

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