(Updates with economist's comment, market reaction)
By Nigel Davies
LONDON, Feb 2 (Reuters) - The steep pace of contraction in euro zone manufacturing business activity showed some signs of easing in January but still pointed to a deep recession, leaving scope for further ECB rate cuts, data showed on Monday.
While the monthly survey of around 3,000 manufacturers showed some slowing in the pace of decline in France, Italy and Spain, in the euro zone's largest economy, Germany, factory business activity deteriorated more rapidly.
The Markit Eurozone Manufacturing purchasing managers' index for January rose to 34.4 from 33.9 in December, the eighth month in a row the index has been below the 50.0 mark that separates growth from contraction.
That was slightly below the 34.5 flash reading released late last month, but suggested the sector may have seen its fiercest declines in the fourth quarter of last year even if it is still contracting sharply.
A dire outlook for the economy, coupled with a sharp fall in inflationary pressures, provides more leeway for the European Central Bank to cut interest rates to 1.5 percent by March as is widely expected [ECB/INT].
"The January manufacturing PMI for the euro area confirmed the first convincing signs of easing in the pace of recession," said Marco Valli at UniCredit.
"Evidence of bottoming in economic activity makes it very likely that the ECB will remain on hold this week ... (but) a 50 basis point cut in March appears likely, and rates should fall to 1.0 percent by mid-year," he said.
The euro and euro zone interest rate futures mostly shrugged off the data although stock markets, which were down sharply before the figures were released, remained deep in the red.
Meanwhile, the badly hit UK manufacturing sector also showed a small bounce in January. Its PMI rose slightly from December's level but was still its third weakest reading in the survey's 17-year history, triggering a fall in the pound.
PRICES FALLING
Manufacturers across the euro zone are struggling with evaporating global demand. Leading German steel maker ThyssenKrupp recently said it would not rule out making further output cuts, shortening work hours, and job cuts as the recession tore into the country's manufacturing sector.
The PMI also showed companies' costs falling at their fastest pace in the near 12-year survey history. The sub-index slipped to 30.1 from 32.8.
But companies found it increasingly hard to pass on costs, taking the output price index, which began in November 2002, to a record low too.
Official inflation in the euro zone fell to 1.1 percent in January, well below the ECB's target of close but below 2 percent.
Employment in the sector fell at the fastest pace in the survey's history, with that index down slightly further even than the record flash reading.
The euro zone's official unemployment rate rose in December to 8.0 percent, its highest level since late 2006, and German unemployment saw its biggest increase in nearly four years in January.
"We are still talking about a significant recession in the first quarter of this year. Q4 and Q1 could have been the worst in the recession, but the pace of deterioration may start to recede," said Rainer Guntermann at Dresdner Kleinwort.
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(Editing by Ruth Pitchford, editing by Mike Peacock)