* Industrial output falls 0.9 pct in May, below forecasts * Year-on-year output falls 4.3 percent * Data reinforce expectation of rate cuts * June PMI hints at continued deterioration By Asher Levine and Silvio Cascione SAO PAULO, July 3 (Reuters) - Industrial production in Brazil shrank in May for the third straight month, supporting the case for more interest rate cuts and highlighting a persistent challenge for policymakers as they struggle to revive a slowing economy. Brazil's industrial output slumped 0.9 percent in May from April, government statistics agency IBGE said on Tuesday, accelerating its pace of decline from the previous month and falling below most analysts' already pessimistic forecasts in a Reuters poll. Brazil's lagging manufacturing sector is partially responsible for the economy's sluggish expansion in the last three quarters, as a global slowdown hit producers already struggling with high taxes, a shortage of skilled workers and inadequate infrastructure. The world's sixth-largest economy has been relying mostly on booming retail sales and steady growth in its services sector to avoid a recession and protect the country's jobs. But the central bank and independent analysts forecast for 2012 the worst annual economic growth for Brazil since a mild contraction in 2009, as automakers like Mercedes and General Motors Co start cutting payrolls. "Industrial output in May was a disaster. There's no better word for it," said André Perfeito, an economist at Gradual Investimentos in Sao Paulo, in a note to clients. Yields on interest rate futures fell across the board on Sao Paulo's BM&FBovespa exchange, as the data reinforced investor expectations for more rate cuts to below the current all-time low of 8.5 percent. "Without a doubt, it's one more indicator that points to more cuts in the coming months," said Silvio Campos Neto, an economist at Tendências Consultoria, in Sao Paulo. The central bank rate-setting committee Copom will likely cut its benchmark rate to 8 percent in its next meeting on July 11. Analysts expect rates to end 2012 at 7.5 percent, according to a weekly central bank survey. JUNE WAS LIKELY EVEN WORSE Industrial output had been expected to contract 0.7 percent in May, according to the median estimate of 17 analysts in a Reuters survey. In April, industrial output fell a downwardly revised 0.4 percent, the IBGE said on Tuesday. The data corroborates leading indicators that pointed to weak industrial production numbers in May. The HSBC Purchasing Managers' Index (PMI) for Brazil's manufacturing sector contracted in June for the third straight month and hit its lowest level since October 2011. Intent on reviving growth, President Dilma Rousseff's administration has chopped central bank benchmark interest rates, provided industries and consumers with tax breaks, and vowed to step up government purchases of industrial goods. "I see this as something that is much more structural than cyclical. Most of it has to do with the limits and internal problems here that need to be addressed, the elements that increase the cost of production in the country," Neto added. May's industrial production fell 4.3 percent from a year earlier, more than the 3.3 percent decline predicted in the Reuters poll. Analyst forecasts ranged from a contraction of 2.2 percent to 4.3 percent. Of the 27 industrial sectors surveyed by IBGE, 14 shrank in May from April, including automobiles, foods, and telecommunications equipment. In broader industrial categories, output of capital goods fell a seasonally-adjusted 1.8 percent for the month, the IBGE said. Production of consumer goods fell 2.8 percent from April, and intermediate goods rose 0.2 percent.