By Martin Santa and Paul Carrel
BRUSSELS/FRANKFURT (Reuters) - An unexpected drop in euro zone inflation raises pressure on the European Central Bank to consider fresh policy action next week to counter deflation risks and support a weak euro zone recovery that may be running out of steam.
Inflation slowed this month to 0.7 percent from 0.8 percent in December, confounding market expectations for a rise to 0.9 percent and matching a low hit last October. The ECB responded then by cutting its interest rates to record lows.
The latest weakening of price pressures took the inflation rate further below the ECB's target of just under 2 percent and will fan investor concerns that deflation may be gripping the 18-member bloc as it starts to exit a sovereign debt crisis.
The inflation data would "set alarm bells ringing at the ECB," said Commerzbank economist Peter Dixon, adding:
"With some of the sentiment numbers in the course of recent weeks having beaten expectations, I don't think it is going to be time next week for the ECB to press that panic button".
A survey released last Thursday showed the euro zone's private sector started 2014 in much better shape than expected, with stronger growth across the region marred only by a continued downturn in France.
The ECB's policy conundrum is complicated by a sell-off in emerging markets that risks pushing up the euro's exchange rate - a development that would keep downward pressure on prices and could snuff out the robust start to 2014 for business.
ECB policymakers meet next Thursday.
Highlighting the bank's capacity to act if it wants to, Executive Board member Benoit Coeure said central banks have tools available to lift low inflation back to target even when interest rates are at zero.
"There are monetary policy instruments that could be used in the event of downward risks to medium-term price stability, even if the nominal interest rate is constrained by the zero lower bound," Coeure said.
After their January policy meeting, ECB President Mario Draghi set out two scenarios that could trigger fresh policy action: a deterioration in the medium-term inflation outlook and an "unwarranted" tightening of short-term money markets.
The ECB will present fresh economic forecasts from its staff in March, and a downward revision to the inflation or growth projections could prompt the Governing Council to ease policy.
Although the ECB cut in November after the slowdown in inflation a month earlier, policymakers on the 24-member Governing Council focus on the medium-term outlook rather than monthly swings in prices.
"If they are going to cut rates, which I think they will, it's more likely that they will hold off until March," said Commerzbank's Dixon.
Speaking in Budapest, ECB Governing Council member Ewald Nowotny said he expected very weak growth in the euro area this year.
The outlook remains fragile despite the ECB's move last November to cut its main interest rate to a record low of 0.25 percent, and to lower the deposit rate it pays banks for holding their cash overnight at the central bank to zero.
In money markets, the second potential trigger for ECB action, a reduction in the amount of excess cash sloshing around in the financial system put upward pressure on overnight lending rates early this year.
Banks stocked up on ECB cash this week, however, and are easing back on early repayments of ECB crisis loans. Together, these factors are expected to keep enough excess cash in the system to hold down short-term market rates.
After the release of the inflation numbers on Friday, short-term money market rates fell on increased bets that the central bank will ease policy further later this year.
Money market rates suggest investors expect the ECB to hold fire at its meeting next week: forward overnight bank-to-bank euro lending rates dated for the February meeting, at 0.18 percent are higher than the spot Eonia rate of 0.155 percent.
The downward trajectory of money market rates maturing beyond February, however, indicates expectations the ECB may ease its policy later this year.
A separate Eurostat data release on Friday showed the euro zone unemployment rate stuck near a record high at 12 percent for the third month running. It is widely expected to ease only very modestly in the coming quarters.
"We expect further falls in inflation going forward," said Nick Kounis at ABN Amro. "The high levels of unemployment and strong euro all suggest there is further downside."
Kounis suggested the ECB could stop weekly operations to sterilise its holdings of government bonds bought under a terminated bond-buy programme - a step that could increase the money supply and fuel inflation.
"If that doesn't work there could be a rate cut in March or April. It would be a mini-cut, it's not our central call but maybe 10 basis points," he said.
(Additional reporting by Jan Lopatka in Budapest and by Emelia Sithole-Matarise in London; Editing by Catherine Evans)