Among the legions of Brazil-watchers who were caught off guard by last week's 50 basis point interest rate cut, count President Dilma Rousseff.

This was a surprise for us, too, a source close to the president said in describing her reaction. We thought it would be unchanged, or they (the central bank) would cut by 25. No one expected 50.

While Brazil's central bank seems to have surprised virtually everyone by slashing its benchmark Selic rate to 12 percent last Wednesday, officials with knowledge of the decision told Reuters that the move was justified by ugly data indicating that the economy will slow more sharply than expected, and could possibly contract, in coming months.

The darker outlook could further roil Brazil's currency, stock and interest rate futures markets, which have already suffered heavy volatility since the rate cut. Wednesday was a market holiday in Brazil.

Many investors are concerned that the cut was premature or motivated by political pressure. They worry that inflation, already at a six-year peak of 7.2 percent, could stay high.

The bank is due on Thursday to release the minutes of its August 31 meeting, which will provide a more detailed accounting of the rationale behind its first rate cut since 2009.

The officials, who spoke on condition of anonymity to describe the bank's thinking before the minutes are published, said data shows Brazilian manufacturers and other companies have been hit hard by the global economic crisis that intensified in August. That pessimistic view is supported by recent anecdotal evidence such as Ford and Volkswagen's separate decisions to cut back auto production here.

Brazilian consumers are also feeling the effect of the five interest rate hikes that had occurred this year prior to last week's cut, the officials said. They said the central bank is now working with a forecast of just 3.5 percent economic growth for this year -- less than half last year's pace, and below most private-sector estimates.

The main IPCA consumer price index could even decline on a monthly basis in coming months, they said.

Our numbers are really, really ugly, one official said.

The account of Rousseff's surprise at the cut, which was corroborated by a second official, would seem to dispel concerns that the central bank acted because of political pressure from the president, who has made no secret of her desire for Brazil's rates to converge over time with those in the developed world. While Brazil's central bank does not enjoy formal independence, Rousseff and previous presidents have in practice given it autonomy to make rate-setting decisions.

Yet Rousseff's reaction raises other, perhaps equally worrying questions: If the decision surprised even her -- a trained economist who meets regularly with central bank chief Alexandre Tombini -- then was the rate cut clearly premature?

Also: Why didn't the bank communicate its intentions better to markets and officials beforehand? And what are the risks if the economic forecasts prove wrong -- and Brazil's economy continues to expand at a brisk pace, driving inflation that is already well beyond the official target range?

NOBODY SAW IT COMING

Confronted with such questions, officials said the central bank's leadership believed that the economic outlook had changed so drastically in August -- especially abroad -- that it simply could not afford to wait until the next rate-setting meeting on October 18-19 to make a major cut in rates.

The world has turned upside down since July, one of the officials said.

Most independent economists are more sanguine -- or at least believed the impact on rates would be more limited.

In a Reuters poll taken a week before the rate decision, all 20 analysts forecast the bank would leave the Selic unchanged. That view evolved as Rousseff and her economic team announced new budget spending goals they said would allow for interest rates to come down over time, and by the day of the decision, interest rate futures markets were pricing in roughly a 60 percent possibility of a 25 basis-point cut.

Asked how traders and economists got it so wrong, the official said the central bank's leadership had clearly telegraphed its concern over the darker global outlook, and that anyone who paid close attention to the bank's public statements could have anticipated the cut was coming.

The bank's dovish stance has been somewhat undermined by the release of two economic data points since the cut.

Second-quarter gross domestic product (GDP) data released on Friday showed that economic growth is decelerating, but not to an extent that shocked Wall Street. Inflation on an annual basis continued to rise in August beyond the 6.5 percent ceiling of the bank's target range, according to data published Tuesday.

CHALLENGE GROWS TO KEEP BUDGET IN CHECK

Officials said the third quarter is likely to be far harder on the economy. They said a GDP contraction in quarter-on-quarter terms is possible -- a possibility echoed by some Wall Street firms such as Credit Suisse.

Among the evidence supporting the darker view: A central bank economic activity index that fell in June compared to May, the first such fall since 2008. A senior member of Rousseff's economic team also cited new internal data showing that sales of motorcycles -- the ultimate symbol of the consumer boom among Brazil's emerging class -- were flat in August compared to 2010 after years of double-digit growth.

Those data also suggest that Brazil's economic slowdown is about more than just global problems: that it is also being triggered by local issues such as manufacturers struggling under the weight of an overvalued currency, and consumers who are highly indebted after years of heavy spending growth.

Tombini, the central bank chief, has been saying publicly since at least May that inflation on an annual basis would likely peak in August. Prices could even fall in coming months as the economy abruptly slows, officials said, bringing annual inflation back below 6.5 percent by year's end.

For that to actually happen, the economy will not only need to slow, but workers must back off their requests for large annual wage increases in the double digits. Put another way: more Brazilians will have to come to come around to the view that the boom years here are over, which will take time.

Rousseff will also have to reduce fiscal pressure on the economy by following through on her commitment to limit spending through the end of the year. She may need to make additional cuts in 2012, as Finance Minister Guido Mantega told Reuters was possible last week.

Officials said Rousseff is ready for the challenge if that means that rates can fall in a meaningful way.

People are complaining that the central bank has lost its independence, an official said. But the irony is that it's really the Treasury that has lost its independence, because now if spending is not kept under control, it's going to be very difficult (on the economy) with rates so low.

(Editing by W Simon )

Credit Suisse