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* March IBC-Br activity index down 0.35 percent, below forecast
* Brazilian activity hardly picked up in first quarter
* Weak recovery likely to prompt more interest rate cuts
* Government prepares more stimulus to support activity
By Alonso Soto and Tiago Pariz
BRASILIA, May 18 (Reuters) - Economic activity in Brazil fell in March for the third straight month, data showed on Friday, a surprisingly weak performance that may lead the central bank to slash its benchmark interest rate to all-time lows and prompt further stimulus measures from President Dilma Rousseff.
The central bank's IBC-Br economic activity index , a closely watched proxy for gross domestic product, contracted 0.35 percent in March from February, the bank said on Friday. Most analysts had expected activity to rise 0.5 percent.
The weak reading means Brazil's economy has remained stagnant since nearly falling into recession in the second half of 2011. In the fourth quarter, the economy expanded just 0.30 percent, a figure that could be easily revised downward when fresh GDP data are released on June 1.
In addition to more interest rate cuts from the central bank, Rousseff is likely to announce new stimulus measures next week to offer cheaper credit to buy construction materials as well as tax breaks on consumer loans, senior government officials told Reuters.
Economic activity also contracted in January and February in what is expected to be a very weak quarter for the economy despite a barrage of stimulus measures to revive growth.
Concerned with market sentiment after the weak data, one senior official said the administration forecasts growth of around 0.4 percent in the first quarter from the fourth quarter, in line with many analysts' expectations.
"Growth this year will be low, without a doubt. We will see the effects of the stimulus in the second half of the year and in 2013," said Andre Perfeito, chief economist with Gradual Investimentos in Sao Paulo. "Lower growth will ultimately give the green light for the central bank to be more aggressive."
Brazil's economy is widely seen growing in full-year 2012 slightly above the meager 2.7 percent posted last year as robust domestic demand only partially offsets a sluggish industrial sector. Brazil's GDP grew a staggering 7.5 percent in 2010.
In the first quarter of the year, activity grew only 0.15 percent from the previous quarter, according to Reuters calculations based on the central bank's data. Activity in February versus January was revised down to a drop of 0.38 percent from the previously reported 0.23 percent slide.
The struggling recovery effort in the world's No. 6 economy will likely prompt the central bank to bring its benchmark Selic interest rate to a record low from the current 9 percent. The bank, which has already trimmed 350 basis points off its Selic rate since August, will make its next rate decision on May 30.
Yields on Brazil's interest rates futures fell across the board on Friday as more investors expected the central bank to keep the size of its rate cuts at 75 basis points per meeting.
MORE STIMULUS AHEAD
Earlier this week, Mantega scrapped his initial economic growth forecast of 4.5 percent for the year and senior officials now see expansion closer to 3 percent.
The government is also considering slashing the financial operations tax, or IOF, on consumer credit of over one year to 2 percent from the current 2.5 percent plus a new credit line of up to 20,000 reais ($10,000) for people to buy construction material, government sources said.
The officials, who declined to be named, said the government could also extend tax breaks on some construction materials.
Many of the country's economic woes stem from what is known as the "Brazil cost" - a mix of high taxes, interest rates, labor costs and infrastructure bottlenecks that strangle businesses facing stiff competition abroad.
Even as manufacturers struggle, domestic demand remains surprisingly strong as Brazilians continue to spend on foreign-made clothes and home appliances.
A worsening debt crisis in Europe also poses a challenge for Brazil as international credit lines dry up and global demand for local products falls.
Rousseff, a career economist, is sticking to fiscal austerity to allow the central bank to continue easing monetary policy. She is also pressing private-sector banks to slash rates in tandem with the central bank's falling benchmark rate.
The stimulus will likely pay off in the second half of the year but will not be enough to bring back the high growth rates that made Brazil one of the world's most dynamic economies.
Rousseff, who enjoys record-high popularity since she took office in January 2011, may face years of mediocre growth ahead as the former star of the BRICS group of major emerging economies quickly loses its shine. The grouping also includes China, Russia, India and South Africa.
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