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By Luciana Lopez

SAO PAULO (Reuters) - Brazil's economy grew 8.8percent in the second quarter compared with a year earlier,defying predictions of a steep slowdown as booming investmentand strong consumer demand helped the country outshinestruggling economies in the developed world.

Gross domestic product expanded 1.2 percent in the secondquarter from the first in addition to its breakneckyear-on-year pace>, the government's statisticsagency IBGE said on Friday.

That outstripped expectations of 0.7 percent quarterly and8 percent annual growth in a Reuters survey, and fueledspeculation that interest rates may rise again in 2011 tocontrol inflation and prevent overheating.

The solid growth in Latin America's largest economy -- andthe world's eighth-largest -- adds more evidence to the growingclout of emerging markets, many of which have posted strongergrowth rates this year than more developed nations.

With a presidential election only a month away, the robustgrowth figures could give an added boost to ruling partycandidate Dilma Rousseff, who is already surging in the pollsthanks to the popularity of her political benefactor, outgoingPresident Luiz Inacio Lula da Silva.

The annual growth came largely on a 26.5 percent surge incapital spending, a sign that Brazilian companies are investingto keep up with future demand. Industrial output grew 13.8percent and household consumption expanded 6.7 percent even asinterest rates rose during the quarter.

The capital spending bodes well for Brazilian growth,because those expenses tend to stoke price pressures less thansome other kinds of spending.

But the second-quarter expansion was still fast enough tofeed expectations of monetary tightening in 2011.

"Even though there has been a small slowdown it was still avery strong quarter, driven by family spending and domesticdemand," said Marianna Costa, an economist with LinkInvestimentos. "Strong activity shows that the probability of anew cycle of interest rate hikes next year is higher."

Yields on interest rate futures contracts broadlyrose on the news, as investors saw the faster-than-expectedgrowth eventually leading to higher borrowing costs.

The yield on the contract due January 2012 the mostactively traded of the morning, rose to as high as 11.41percent from 11.31 percent.

RATE HIKES IN 2011?

Brazil's economy grew a whopping 9 percent in the firstquarter from the year-ago period, its fastest pace in more thana decade and, many said, unsustainable.

The government stepped on the brakes: The tax breaks oncars and home appliances that had brought Brazilian shoppersinto malls and showrooms faded, and the central bank broughtthe benchmark interest rate up from a record-low 8.75 percentto 10.75 percent.

"This (GDP growth) number shows that the economy is stillgrowing briskly, even after the withdrawal of the measures thatfueled exceptional growth in the first quarter," said NewtonRosa, chief economist with SulAmerica Investimentos.

On Wednesday the cental bank said that the interest ratehikes had done their job, and it held the Selic rate at 10.75percent, ending a tightening cycle that began in April.

But with the economy barely slowing in the second quarterfrom its breakneck pace of the first, the government might needto slow things down more next year to prevent inflation fromspeeding too far above the official target of 4.5 percent, plusor minus 2 percentage points.

Brazil's growth could also put it on pace to move up theranks of world economies. Already, a slew of politicians havesaid the country could become the world's fifth-biggest incoming years, from its current ranking at number eight,according to the International Monetary Fund.

The economic growth of recent years has brought millions ofpeople out of poverty and boosted the massive popularity ofLula, who will leave office on Jan. 1, 2011.

His candidate in the Oct. 3 election, Rousseff, is closelyidentified with his policies, and some polls predict she'll beelected in the first round of voting.

For details on the IBGE's GDP figures see:http://www.ibge.gov.br/home/presidencia/noticias/noticia_visualiza.php?id_noticia=1705&id_pagina=1 (Additional reporting by Rodrigo Viga Gaier and StuartGrudgings in Rio de Janeiro and Vanessa Stelzer and SamanthaPearson in Sao Paulo, Editing by Todd Benson and )