Jan. 6 (Bloomberg) -- Europe’s inflation rate fell to the lowest in more than two years in December as oil prices plunged and consumer spending slumped, increasing the scope for the European Central Bank to reduce borrowing costs further.

Consumer-price inflation in the euro area slowed to 1.6 percent from 2.1 percent in November, moving below the ECB’s 2 percent ceiling for the first time since August 2007, the European Union statistics office in Luxembourg said today. A separate report showed the region’s services industry contracted for a seventh month.

As the global financial crisis damps economic growth, slowing inflation may prompt the ECB to extend a series of interest-rate cuts that already has seen its key rate fall by 1.75 percentage points since early October. The euro extended declines after the inflation report, falling to a three-week low.

The figures “further weaken the hands of the hawks on the ECB governing council and increase the prospect of the ECB cutting interest rates next week,” said Martin van Vliet, an economist at ING Groep NV in Amsterdam. “Looking ahead, inflation is set to slip further below the ECB’s target.”

Economists expected inflation to ease to 1.8 percent in December, according to the median of 28 forecasts in a Bloomberg survey. The euro, which fell to as low as $1.3313 today, was down 1.8 percent to $1.3391 at 4:05 p.m. in London.

Economy Slumps

The ECB last month predicted the euro-area economy will shrink about 0.5 percent this year, which would be the first annual drop in gross domestic product since the euro’s introduction a decade ago.

Retail sales fell for a seventh month in December, manufacturing shrank at a record pace and lending to the private sector stagnated, reports in the past month showed. Carrefour SA, Europe’s largest retailer, said on Dec. 17 it plans an “aggressive” discounting campaign to protect its market share as consumers scale back on spending.

As global growth slows and energy costs decline amid slackening demand, concerns about deflation are increasing. The price of crude oil has fallen by two-thirds since reaching a record $147.27 a barrel in July.

‘Rate Reductions’

ECB policy makers, who aim to keep the inflation rate just below 2 percent, have indicated that the chances the central bank’s governing council will lower borrowing costs when it meets next week are increasing as data show the economy falling deeper into a recession.

“Monetary policy has given its contribution and should continue to do so if inflation threatens to fall significantly below 2 percent,” ECB governing council member Vitor Constancio told a press conference in Lisbon today. “Any risks of inflation settling well below that level must be preventively contained with interest-rate reductions.”

His pledge echoes comments by ECB Vice President Lucas Papademos on Jan. 4 that lower borrowing costs “could be warranted” if price stability were threatened.

Investors indicate they expect a cut of at least 50 basis points at the Jan. 15 meeting, according to Eonia forward contracts.

Last month, ECB President Jean-Claude Trichet said policy makers were wary of being “trapped” with interest rates too low, while Bundesbank President Axel Weber has said he “would like to avoid” taking the key rate below 2 percent.

The inflation report released today is an estimate. The statistics office will publish a detailed breakdown of the data, including energy-price inflation as well as the core rate, on Jan. 15.

To contact the reporters on this story: Ben Sills in Madrid at bsills@bloomberg.net; Jurjen van de Pol in Amsterdam jvandepol@bloomberg.net.

Last Updated: January 6, 2009 11:25 EST