Euro zone bonds firm as low inflation spurs ECB easing bets
* Euro zone inflation falls way below ECB target
* Fed statement "not as dovish" as markets expected
* Nowotny says ECB will provide more liquidity
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Oct 31 (Reuters) - Euro zone government bonds firmed on Thursday after inflation unexpectedly slowed in October, increasing chances that the European Central Bank could ease monetary policy further.
Data showing inflation fell to a four-year low of 0.7 percent, way under the ECB's target of just below 2 percent, mostly reversing an early dip in bond prices caused by the Federal Reserve being less alarmed than anticipated about the U.S. economy in its post-meeting statement.
Investors had expected inflation to steady at 1.1 percent and some analysts said the surprise drop raised the likelihood that the ECB would at least flag a rate cut or further liquidity injections at its meeting next Thursday.
Euro zone interest rate futures rose across the 2014-2016 curve , pushing their rates lower while other short-term money market rates also fell.
"This very low figure is a bit of a game changer for the ECB and investors because nobody was expecting it to be this low so (monetary policy easing) expectations have increased," said Cyril Regnat, a strategist at Natixis in Paris.
"We don't expect them to act next week but the ECB needs to be more dovish (than at the October meeting) because price stability is the ECB's sole mandate and when inflation is so low the credibility of the ECB is now on the frontline."
The central bank has not sent any clear signals of imminent easing since its last meeting last month and it remains unclear whether it will cut interest rates further or give banks a new round of cheap long-term loans.
Governing Council member Ewald Nowotny earlier said the ECB will provide more liquidity to banks by the time the cheap three-year crisis loans offered in late 2011 and early 2012 expire, but he declined to specify how and when.
Bund futures settled up 15 ticks on the day at 142.00, having hit their highest since Aug. 12 at 142.32 after the inflation data.
Cash 10-year Bund yields, the region's benchmark, fell 1.3 basis points to 1.68 percent while 2-year yields - which are sensitive to shifts in interest rate expectations - 4 bps down at 0.12 percent, lowest since Aug. 1.
Other data on Thursday including below-forecast German retail sales and French consumer spending and record high euro zone unemployment also supported expectations of further ECB easing.
Those prospects lifted lower-rated debt as well, with Spanish 10-year yields falling to their lowest since May 3 at 3.99 percent and equivalent Italian yields dropping 6 bps to 4.12 percent.
The euro zone data outweighed the impact of the statement the Fed gave on Wednesday at the end of its two-day meeting and surprisingly strong data on U.S. Midwest business activity on Thursday which reduced some pessimism that fourth quarter growth in the world's biggest economy would be sub-par.
The Fed kept its $85 billion-a-month asset purchase plan intact, acknowledging the negative impact that a recent stand-off over the U.S. budget would have on the economy and the fact that a recovery in the housing market had slowed.
But it removed a reference to tighter financial conditions from its statement, suggesting greater comfort with the current level of market rates.
Sanjay Joshi, head of fixed income at London and Capital, said he still expected the Fed to hold off from trimming stimulus until April. "But views in the market are very dispersed - some are going for December," he said.
He added the mix of views could make longer-dated bonds more data sensitive and volatile, so he cut the overall duration of his bond portfolio.