UPDATE 1-Surprise drop in euro zone inflation shows deflation risk
* December inflation surprises with drop to 0.8 pct y/y * Concerns that euro zone faces deflationary risks * Euro rises versus dollar after Dec CPI * Producer prices fall in November but ease decline By Martin Santa BRUSSELS, Jan 7 (Reuters) - Euro zone inflation fell in December after a small increase the previous month, increasing the European Central Bank's challenge of avoiding deflation as well as supporting the bloc's recovery. Consumer price inflation in the 17 countries then sharing the euro stood at 0.8 percent year-on-year in the last month of 2013, compared with 0.9 percent in November, data from the EU's statistics office Eurostat showed on Tuesday. December's reading takes inflation back to near a four-year-low of 0.7 percent in October. "Today's figures show that it's too early for the ECB to become complacent about deflation risks, especially in peripheral countries," said Peter Vanden Houte, ING's chief euro zone economist, referring to the bloc's weaker members. An inflation rate that is well below the ECB's target of close-to-but-below 2 percent carries risks in the longer term because it can deflate wages and demand, depressing the economy. Reacting to the data, the euro rose to $1.3646 from $1.3618 on speculation the ECB could consider more steps to support the economy. The October drop in inflation was the first fall below 1 percent since February 2010 and prompted the European Central Bank to cut its key interest rate to a new record low of 0.25 percent in November. Still, the euro zone is far from the deflation that Japan suffered from the early 1990s. ECB President Mario Draghi said last week there were no signs of deflation or an urgent need for another rate cut, but added that it was vital to avoid a scenario where inflation gets stuck permanently below one percent and slips into a danger zone for the economy. "While we believe that for the time being the ECB will keep its monetary policy unchanged, not much is needed to push the central bank into action," said Vanden Houte. Analysts see the ECB staying on hold at its rate-setting meeting on Thursday, while watching out for any action the bank may take in reaction to current low inflation environment. "We believe the ECB will most likely enact its Long-Term Refinancing Operation (LTRO) in the next few months, which may very well be tailored specifically towards bank lending," said IHS chief European economist Howard Archer. ECB Governing Council members have signalled the bank will provide more money to banks by the time the cheap long-term loans it has already made expire. The ECB injected more than 1 trillion euros into the banking system via three-year loans in December 2011 and February 2012, which means the first tranche of repayments is due in late 2014. Eurostat's separate data release showed euro zone industrial producer prices eased their decline in November to fall by 0.1 percent on the month after a 0.5 percent drop in October, putting the annual rate at -1.2 percent, compared with a nearly four-year low of -1.3 percent seen in October. The monthly drop was led by a 0.2 percent fall in costs of intermediate goods while prices of capital, durable, non-durable goods and energy prices were flat compared with October. Changes in producer prices, unless absorbed by retailers, eventually translate into changes in the consumer price index. Eurostat's detailed inflation data breakdown for December, country by country, will be published on Jan. 16.