By Walter Brandimarte and Silvio Cascione
SAO PAULO/BRASILIA (Reuters) - Brazilian President Dilma Rousseff's crusade to win back investor confidence has entrusted policymakers with the tough mission of hiking interest rates while major central banks cut them, raising the prospect of another recession in Latin America's biggest economy.
As it boosted the benchmark Selic rate to 12.25 percent on Wednesday, the third consecutive rate hike since Rousseff won re-election in October, Brazil's central bank sought to deliver on its pledge to do "whatever it takes" to bring down inflation currently running at about 6.5 percent annually.
The move left the Brazilian central bank at odds with the European Central Bank, which unveiled a massive bond-buying program on Thursday, as well as policymakers in Canada, Denmark, India and Turkey, who recently cut interest rates after the sharp drop in oil prices and forecasts of slower global growth.
Brazil's strategy seems to be paying off, for now.
Investors, also encouraged by a package of austerity measures unveiled this week, have been cautiously buying government bonds and driving long-term interest rates lower.
The Brazilian real (BRL=) has gained 3 percent since the beginning of the year while returns on local-currency government bonds have totaled 4.9 percent in dollar terms during the same period, according to a benchmark JP Morgan index (.JGEMCBB).
That has provided rare good news for Rousseff, who has otherwise been battered by a weak economy, plunging business confidence, energy blackouts and a corruption scandal since she began her second term on Jan. 1.
Javier Murcio, a Boston-based portfolio manager at Standish Mellon Asset Management, which oversees $10 billion in emerging market assets, said the fund was currently "slightly overweight" on Brazil's local currency debt.
"If we see an improvement in the macro conditions, then we will go more overweight," he said.
Dollar inflows have also picked up as investors try to take advantage of one of the world's highest interest rates. About $2.3 billion have flown into Brazil during the week ending Jan 16, practically offsetting outflows of $2.4 billion recorded during the first nine days of the year, central bank data showed (BRCAPF=ECI).
Yet the central bank is going down a dangerous path that could drive Latin America's largest economy into a recession for the second time in less than two years, following a brief contraction last year.
That, in turn, has investors wondering if Rousseff, a leftist, will have the stomach needed to maintain unpopular policies such as interest rate hikes.
"The big question is whether these policies will have the necessary political backing," said Enestor dos Santos, an economist with BBVA in Madrid. "Perhaps the initial plan was to implement a small adjustment that wouldn't take the economy into a recession but, if it doesn't happen like that, will the government continue to support it?"
A pullback from recently-unveiled austerity measures could rock Brazilian financial markets, driving investors out of the country and costing Brazil its coveted investment-grade rating.
Rising interest rates have already hurt Brazilians' purchasing power, with 2014 retail sales believed to have posted their worst performance in 11 years. Mortgages also became more expensive after state-lender Caixa Economic Federal last week raised lending rates to as high as 11 percent from 9.2 percent.
Economists already expected a tough year, with forecasts for a mere 0.32 percent economic growth, according to a weekly central bank survey of about 100 analysts.
Other economic headwinds abound.
A widening corruption scandal at state-run oil company Petrobras (PETR4.SA) has slowed investment in the oil sector while a prolonged draught is sharply increasing the cost of Brazil's hydroelectric-based power generation.
Lower commodity prices also make it harder for the country to restore its trade balance, which in 2014 posted its first deficit in 14 years.
Despite such problems, the central bank on Wednesday left the door open to raise the base Selic rate by another 50 basis points in its next meeting rather than slow the pace of monetary tightening, as many economists expected.
Banks have been slashing their forecasts for Brazil's economic growth as a result. Some, such as HSBC and Credit Suisse, now expect gross domestic product to contract 0.5 percent this year.
"There is no doubt (the central bank's policy) is having a negative impact on the economy," said BBVA's Santos.
(Additional reporting by Gertrude Chavez-Dreyfuss and Daniel Bases in New York, Alonso Soto in Brasilia; Editing by Brian Winter and Andrew Hay)