Euro zone economic sentiment fell more than expected in August, underlining prospects for slower economic growth and expectations that the European Central Bank may cut inflation forecasts and cease raising interest rates.

A monthly European Commission survey showed economic sentiment in the 17 countries using the euro, a good indication of future economic activity, fell to 98.3 in August from a revised 103 in July with optimism declining in all sectors.

Economists polled by Reuters had expected a fall to 100.5.

The decline in sentiment clearly indicates that the euro zone economy has lost a lot of momentum. As a result, growth will probably remain very sluggish in the second half of the year, while the risks are tilted to the downside, said Aline Schuiling, economist at ABN AMRO Bank.

The European Central Bank raised rates twice this year by 25 basis points each time to 1.5 percent but a worsening of the euro zone's debt crisis and economic outlook has prompted markets to price out any chance of further hikes for the foreseeable future.

While it would be a step too far to expect the bank to lower its main interest rates any time soon, thereby implicitly admitting that this year's tightening was a mistake, we are probably facing a long period of low and stable interest rates, said Peter Vanden Houte, economist at ING bank.

Indeed, in the wake of a continuously tightening fiscal policy and the inability of European politicians to come up with a structural solution for the debt crisis, a loose monetary policy seems to be the only medicine left to prevent a painful fall back into recession, he said.

GLUM

The sentiment index for industry fell into negative territory -- at -2.9 -- for the first time since September 2010, against expectations of a drop to -1.5 from a downwardly revised 0.9 in July.

The index for services halved to 3.7 against expectations of an easing to 6.3 from 7.9 and consumer sentiment declined to -16.5 from -11.2, also more than expected.

It is evident that both businesses and consumers are very worried by the slowdown in domestic economic activity, heightened financial market turmoil, ongoing serious concerns over the euro zone sovereign debt situation and increased fears over the health of the global economy, said Howard Archer, economist at IHS Global Insight.

The euro zone needs strong economic growth to help it put an end to the sovereign debt crisis which has been spreading from peripheral countries like Greece, Portugal and Ireland to the bigger euro zone economies, such as Spain and Italy.

But euro zone growth slowed to 0.2 percent quarter-on- quarter in the April-June period from 0.8 percent in the first three months of the year and the European Commission expects growth to slow down further as a result of high oil prices in the first half of the year and financial market turmoil.

Some factors that depressed growth in the first half of the year -- high oil prices and supply-chain problems due to the tsunami in Japan -- will wane, but the escalating sovereign debt crisis and recent turmoil of financial markets has hurt confidence and activity, ABN AMRO's Schuiling said.

Economists said the euro zone economy may grow only 0.1 percent in the third quarter and come to a halt in the fourth.

The (economic sentiment) index is now consistent with annual GDP growth of about 0.7 percent, implying that activity could fall outright in Q3 compared to Q2, said Jennifer McKeown, economist at Capital Economics.

This also suggests that even our far-below-consensus forecast for euro-zone GDP to rise by 0.5 next year might prove optimistic, she said.

Separately, the Commission's business climate indicator, which points to the phase in the business cycle, fell more than expected to 0.07 in August from 0.44 in July. Economists polled by Reuters had expected a decline to 0.15.

The survey said producer inflation expectations fell to 8.7 percent in August from 12.4 in July while consumer price expectations inched higher to 26 from 25.4.

The plunge in euro zone business and consumer confidence in August, coupled with signs that underlying inflationary pressures are easing, reinforces belief that the ECB will hold off from raising interest rates again for some considerable time to come, said IHS's Archer.

Indeed, the data fuel belief that the ECB's ultimate next move may actually be to trim interest rates, although it is likely to need sustained euro zone economic weakness to get the ECB to do a U-turn on interest rates, he said.

(Editing by Rex Merrifield and Patrick Graham)

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