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By Jason Webb
MADRID, Oct 30 (Reuters) - Spain's EU harmonised inflation eased more sharply than expected in October, data showed on Thursday, prompting the country's economy minister to suggest the European Central Bank has more room to cut interest rates.
Lower inflation in Spain, combined with figures on Wednesday showing a half point drop in German inflation and weaker Belgian consumer price numbers on Thursday, underscore expectations for a 0.4 percent drop in euro zone inflation to 3.2 percent, due on Friday.
The Spanish data came with figures showing plummeting retail sales, providing more evidence that slowing inflation is a sign of a hard landing for Spain as its construction boom turns to bust and banks cut back on loans in the credit crisis.
Inflation dropped to 3.6 percent in October from 4.6 percent in September, preliminary data from Spain's National Statistics Institute showed.
"It dropped much more than I had anticipated, I was going for 4 percent," said Jose Garcia Zarate from 4Cast in London, adding that falling oil and food prices were largely responsible.
"I suppose it's a sign that all sectors of the economy are engaging in discounting because private consumption has pretty much come to a standstill," Garcia Zarate said.
The inflation figure -- below a median forecast of 3.9 percent in a Reuters survey of 15 analysts -- came as the institute also reported that retail sales fell by 7.2 percent in calendar-adjusted terms during September.
Economy Minister Pedro Solbes said lower inflation should encourage the European Central Bank, which has already indicated it is preparing to cut interest rates at its next meeting.
"This gives them more room to cut interest rates and generate more economic activity. I think it's very positive," Solbes told Spanish radio.
The government has said inflation should dip below 3 percent next year unless oil prices rebound.
But falling prices are being accompanied by heavy discounting in shops as many businesses go under. Unemployment has risen by 800,000 people in 12 months to 2.6 million.
The European Commission has forecast Spain's economy will contract in the second half of this year, as the country pays the price for a steep accumulation of household and company debt during its decade of boom until 2007.
With a current account deficit at about 10 percent of gross domestic product and poor competitiveness which cannot be remedied by devaluation due to euro membership, Spain's economy could contract by 0.5 percent next year, said Giovanni Zanni of CSFB.
This would be worse than the 0.3 percent contraction CSFB forecasts for the euro zone as a whole, as the country struggles to replace the hole in its economy left by the shrivelling construction sector, which accounted for 18 percent of GDP at the height of the boom.
"These adjustments are not normally immediate," said Zanni.
Slowing retail sales come despite a 38 billion euro spending programme aimed at supporting the economy by the government, which is forecasting a public sector deficit of 1.5 percent of GDP this year after a 2.2 percent surplus in in 2007.
September's retail sales data compared to a drop of 5.9 percent in August and a median estimate in a Reuters survey of 6 analysts of a 6.3 percent fall.
In inflation-adjusted terms, retail sales fell by 5.6 percent compared to a 7.5 percent fall in August. (Additional reporting Manuel Maria Ruiz and Robert Hetz; Editing by Louise Ireland)