Euro zone inflation dropped below 3 percent for the first time in three months in December, kicking off a slowdown economists expect will revive deflation fears and tempt the ECB to cut rates below 1 percent for the first time in its history.

Official Eurostat figures estimated that consumer prices in the 17 countries sharing the euro rose 2.8 percent year-on-year in December, down from 3.0 percent year-on-year rises in November, October and September.

Following the recent souring of the European and global economy, economists widely share the view that inflation has now peaked and predict a short, sharp slowdown in the months ahead to back below the 2 percent sweetspot the European Central Bank judges to be optimal for a healthy economy.

As Eurostat's figures are only an estimate at this stage no detailed break-down of the inflation numbers is available. The slowdown was widely expected by analysts with most putting it down to lower energy and steadier food prices. Assuming that the oil price does not rise again, we see this component knocking about 1 percent off the headline rate in 2012. Food inflation should also slow as the effects of past rises in agricultural commodity prices fade, said Ben May, economist at Capital Economics.

We expect the headline inflation rate to plunge well below the ECB's 2 percent price stability ceiling by the middle of the year.

A new poll of economists by Reuters on Wednesday showed a clear majority now see the ECB cutting interest rates below the 1 percent mark for the first time ever in the next few months, although fewer than a third seeing it printing money in the way the U.S. and UK central banks are.

The bank has made back-to-back 25 basis points cuts since Mario Draghi took over as president in November. It has also gone back into full crisis mode, firehosing strained euro zone banks with almost half a trillion euros of ultra-cheap three-year loans and loosening its borrowing rules yet further.

RATE EXPECTATIONS

Rate cut expectations are being framed by the euro zone's ongoing sovereign debt crisis which has started to take its toll on the bloc's 9.2 trillion euro economy.

The downturn in the euro zone's vast private sector economy moderated in December thanks to a better performance by leading economy Germany. But purchasing managers surveys showed the region as a whole still looked on course for recession.

Markit's Eurozone Composite PMI rose in December to a better than expected 48.3 from 47.0 in November. The index, however, was below the 50 mark that divides growth and contraction for the fourth month in a row.

Despite the tentative signs of stabilization over the past couple of months, the average (PMI) index for Q4 2011 still points to the steepest quarterly contraction since the beginning of 2009 while forward-looking indicators point to no significant improvement in early 2012, analysts at HSBC said.

Today's release highlighted the growing variations between the core as Germany and France registered an expansion in service sector output, while Italy and Spain continued to contract with austerity measures now starting to bite, they added.

MIXED SIGNALS

A 4 billion euro German bond auction also saw robust demand, recovering after troubles experienced last month.

Elsewhere, worries about the health of euro zone's banks continued to weigh on stock market sentiment.

European shares slipped from five-month highs after Italy's embattled UniCredit was forced to offer an almost 70 percent discount on a 7.5 billion euro rights issue, raising fears cash-strained banks across the bloc face a brutal battle in the coming months when many will have to raise funds.

The European Banking Authority has told banks they must to find 115 billion euros of extra capital by the end of June to reach a minimum core capital level of 9 percent -- with lenders in Italy, Spain and Germany needing the most.

At 8.0 billion euros, UniCredit's shortfall is the biggest of any bank after Spain's Santander , which needs 15 billion euros to meet the EBA requirements -- a crucial plank of efforts by euro zone leaders to avoid financial disaster.

The ECB pumped almost half a trillion euros of ultra-cheap, three-year loans to over 500 banks at the end of last month, in its latest bold attempt to bolster the sector and prevent banks damaging the economy by slamming the brakes on lending to firms and consumers.

Data from the central bank has shown that the cash deluge is starting to make an impact. While around 65 percent of the money banks take from the ECB is still being hoarded by banks rather than lent, they have now began to scale down their intake of shorter-term ECB loans.

Another positive on Wednesday was that banks also halved the amount of dollars they borrowed from the ECB. Demand had jumped in December as the crisis saw traditional dollar source such as U.S. money market funds cut their lending to European banks.

(Reporting by Marc Jones. Editing by Jeremy Gaunt.)

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