(Adds central bank comments, market reaction)
By Alonso Soto and Silvio Cascione
BRASILIA, March 27 (Reuters) - Brazil's central bank raised its 2014 inflation forecast sharply on Thursday and said it sees the economy growing at a moderate pace, signaling it may prolong its cycle of interest-rate hikes to battle naggingly high inflation in an election year.
The central bank increased its 2014 inflation forecast to 6.1 percent from its previous estimate of 5.6 percent as a severe drought in southern Brazil hurt crops and raised food prices.
In its quarterly inflation report, the bank also raised its estimate for inflation in 2015 to 5.5 percent from 5.4 percent, highlighting stubbornly high prices that have worried investors for the last three years.
Both estimates are well above the center of the bank's official inflation target: 4.5 percent, plus or minus two percentage points.
"Our outlook does not envisage inflation slowing toward the target midpoint," Carlos Hamilton Araujo, the central bank's economic policy director, told a news conference.
High inflation could hurt President Dilma Rousseff's re-election chances in the October general election. Her approval ratings have dropped sharply from November, according to a poll on Thursday.
The gloomier inflation outlook signals that policymakers are not yet ready to halt a year-long monetary tightening cycle even if it means further slowing Latin America's economy during an election year.
Many analysts believed the bank was near the end of the cycle when it opted for a smaller rate increase at its last monetary policy meeting in February.
But yields on interest rate futures <0#DIJ:> rose on Thursday, suggesting traders added to bets for another 25-bps interest rate increase next week and possibly again in May.
"It is going to be 25 bps just because they have hinted at that very strongly. If they had left the door open, I'd expect a 50-bps point increase," said Marcelo Cypriano, economist at Banco Original do Agronegocio, in Sao Paulo.
While some of its Latin American peers are cutting rates to bolster economic activity, the Brazilian central bank has raised its benchmark Selic interest rate a staggering 350 basis points to 10.75 percent since April to contain a surge in prices.
The bank's inflation report reiterated it would remain "especially vigilant" and would act to limit the effects of a surge in food price inflation, which should be temporary.
Araujo said food inflation caused by hot and dry weather earlier in the year will pick up through May, but will subside a bit in June.
The bank forecast 2.0 percent economic growth this year, below the 2.3 percent growth of 2013, partly due to a slowdown in investment.
Sluggish growth and lofty inflation were key reasons for ratings agency Standard & Poor's to slash Brazil's debt rating closer to speculative territory on Monday. (Editing by Chizu Nomiyama, Bernadette Baum, Sophie Hares and Peter Galloway)