(Adds quotes from ECB's Constancio)
* Spanish inflation falls to decade-low of 1.5 percent
* Italian inflation slows to 2.3 percent, less than forecast
* ECB's Papademos says will not accept deflation
By Paul Day and Phil Stewart
MADRID/ROME, Jan 5 (Reuters) - Inflation fell more than expected in Italy and Spain in December, upping pressure on the European Central Bank to keep cutting interest rates to ensure inflation does not fall too far below its 2 percent ceiling.
Spanish inflation fell to a decade-low 1.5 percent as a severe economic slowdown coincided with sharp drops in food and commodity prices. In Italy, annual inflation slowed to a 14-month low of 2.3 percent, from 2.7 percent in November.
The figures come on top of sharp falls in inflation in Germany, the euro zone's biggest economy, and Slovenia. They bolstered economists' expectations of a further drop in euro zone inflation to below the ECB's 2 percent ceiling, increasing the odds of lower interest rates.
ECB Vice-President Lucas Papademos said on Sunday that more rate cuts may be needed to shield the euro zone economy and make sure inflation did not fall too far, stressing that deflation would be kept at bay.
"We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved," he told reporters on the sidelines of the annual meeting of the American Economics Association in San Francisco. [ID:nN04347375]
The euro fell to its lowest against the U.S. dollar since
mid-December
The ECB has reduced its benchmark interest rates by 1.75
percentage points since October to 2.5 percent and markets
expect it to cut by 50 basis points, or more, when it holds its
next policy meeting on Jan. 15.
Inflation in the euro zone, which now numbers 16 countries after the Jan. 1 entry of Slovakia, has retreated steadily from a peak of 4 percent in summer.
Spanish, Italian and German figures were all weaker than expected and economists polled by Reuters expect euro zone inflation to have dropped to 1.8 percent in December, from 2.1 in November, when preliminary figures are released on Tuesday.
Euro zone manufacturers reported input and output prices fell to record lows in December -- with activity doing the same -- according to the Markit Purchasing Managers Index.
Papademos said the ECB expected inflation to fall considerably in mid-2009, possibly turning negative in some countries, but it was likely to return to price stability levels, defined as below but close to 2 percent, by year-end.
He saw "nil" chance of deflation -- a persistent, broad-based fall in prices -- in the region and said the ECB would not let inflation become entrenched at too-low levels.
"Inflation will not be allowed to fall significantly below 2 percent for a protracted period of time, over the medium term, which we do not expect on the basis of our present analysis," he said.
RATE CUTS SEEN
Inflation rates are falling around the world, due to lower oil prices -- which are still about $100 per barrel below their July peak despite regaining ground since Israel launched its Gaza offensive -- and slumping economic growth.
In Asia, Thailand reported that inflation tumbled to a six-year low of just 0.4 percent and in Taiwan, it hit 1.21 percent, the lowest level in 1-1/2 years. [ID:nTP361427]
In Italy, economists had expected year-on-year inflation of 2.4 percent and Spain's European Union-harmonised figure was well below a Reuters forecast of 1.9 percent, and down from 2.4 percent in November.
Papademos's comments contrast with policymakers Yves Mersch and Juergen Stark, who have urged caution in further rate moves, but Bank of Portugal Governor Vitor Constancio said the ECB would do what was needed to meet its target if inflation dips. [ID:nL5259330]
"Policy will respond with reductions in interest rates in line with the objective of maintaining inflation around 2 percent," Constancio he said in Lisbon. [ID:nL5259330]
"Policy does not only worry that inflation rises a lot, but also if it falls a lot."
Analysts said the bank could continue cutting until borrowing rates are as low as 1 percent, citing the fate of oil prices, boosted in recent days by events in the Middle East, as a key factor for inflation going forward.
Last week, preliminary figures from Germany showed inflation slowed in December for a fifth consecutive month to its lowest level in over two years at a national level, measuring 1.1 percent. This was the same as the EU-harmonised figure.
In Slovenia, inflation slowed to 1.8 percent year-on-year in December from 2.9 percent November. The euro zone preliminary estimate will be released at 1000 GMT on Tuesday. (Writing by Krista Hughes; Editing by Toby Chopra and Andy Bruce)