(Adds economists' reaction)
By Jan Strupczewski
BRUSSELS, May 28 (Reuters) - Euro zone economic sentiment improved more than expected in May in a sign the low point of the recession may have passed, but inflation expectations fell again, raising the spectre of deflation.
A monthly survey by the European Commission released on Thursday showed economic sentiment (ESI) in the 16 countries using the euro rose to 69.3 points in May from 67.2 in April, the second improvement from a trough of 64.7 points in March.
Economists polled by Reuters had expected a rise to 69.0.
"Today's data provide further evidence that the recession is easing substantially, but the economy is not yet out of the woods given that...the Economic Sentiment Indicator needs to rise to about 90 to signal the end of the recession," said Marco Valli, economist at Unicredit.
The improvement was fuelled by the retail sector, industry and services. Sentiment among consumers and in the construction sector did not change. [ID:nBRQ007359]
"The present level of the ESI still points to slight contraction this spring," said Christoph Weil, economist at Commerzbank.
"However, the situation should bottom out in the autumn. By that time, the ECB's generous rate cuts and the various economic packages launched will be having a stabilising effect," he said.
Economists noted that the survey showed that inventories in the manufacturing sectors were still seen as too high.
"The index of stocks of finished goods is still well above its long term average," said Clemente de Lucia, economist at BNP Paribas. "This implies that albeit in moderation, destocking is still an ongoing process and it could continue to weigh on activity."
INFLATION EXPECTATIONS FALL AGAIN
The Commission survey also showed that inflation expectations 12 months ahead among households fell again in May to set a new low of -7 points from -2 points in April -- the second consecutive month of expectations of falling prices.
Selling-price expectations among manufacturers fell to -12 from -11 in April, retreating closer to the all-time low of -14 reached in March.
Consumer inflation was 0.6 percent year-on-year in March and April. The EU statistics body, Eurostat, will publish its estimate for May on Friday with economists forecasting a further decline to 0.2 percent.
"It is not deflation yet because it would need more months of negative inflation and negative expectations, but the risk of deflation increases and it is up to the ECB to keep the genie in the bottle," said Carsten Brzeski, economist at ING.
"They (the ECB) need to anchor inflation expectations much higher than now," he said.
The European Central Bank watches inflation expectations closely in its policy decisions, aiming to anchor them at its price stability target of inflation just below 2 percent over the medium term.
ECB officials have said the bank would act to prevent inflation from falling too far below target, even though they saw no risk of deflation despite price falls expected in some euro zone countries in the third quarter.
The ECB has said that for deflation to exist there must not only be a protracted period of negative inflation, but also negative inflation expectations, which would make consumers hold back purchases.
The Commission survey showed that consumers' plans for major purchases over the next 12 months reached a new all-time low of -25 points in May, down from -23 in April.
"It is imperative that the ECB presses ahead with its policy efforts to boost economic activity...as the...survey shows muted consumer inflation expectations and company pricing intentions," said Howard Archer, economist at IHS Global Insight.
But other economists said that while the ECB has left the door open to new steps, it was unlikely to do anything now.
"Signs that growth has reached an inflection point diminish the chances of further significant policy steps in the next few months," said Unicredit's Valli.
(Reporting by Jan Strupczewski, editing by Dale Hudson)