Aug. 7 (Bloomberg) -- European Central Bank President Jean- Claude Trichet said economic growth will be ``particularly weak'' through the third quarter, suggesting policy makers are wary of raising interest rates again to curb inflation.

While the ECB's decision to raise borrowing costs last month was justified by the inflation threat, risks to growth ``are materializing,'' Trichet told reporters in Frankfurt today after keeping the benchmark rate at 4.25 percent. ``Overall, downside risks prevail.''

The euro dropped more than a cent and bonds rose as investors pared bets on higher ECB interest rates. The bank is concerned that the fastest inflation in 16 years will help unions push through demands for higher wages and prompt companies to lift prices. At the same time, record energy costs and the stronger euro are strangling growth. The Bank of England today also kept rates unchanged.

Euro-region economic confidence dropped the most since the Sept. 11 terrorist attacks in July and Europe's manufacturing and service industries contracted for a second month.

``The ECB is acknowledging the economic slowdown,'' said Matthew Sharratt, an economist at Bank of America in London. ``They're still focused on high inflation but the best way to avoid a policy mistake would be to keep interest rates on hold.''

The euro fell as much as 0.8 percent and traded at $1.5376 at 5:10 p.m. in Frankfurt. The yield on the 10-year German government bond fell 8 basis points to 4.26 percent. Bond yields move inversely to prices.

Cuts By Christmas?

Eonia swap contracts, a widely used market gauge of interest- rate expectations, have started to price in rate cuts. The yield on the April contract dropped 15 basis points to 4.16 percent after Trichet's remarks.

``If he was trying to give a neutral, balanced `don't price in rate cuts' speech, then I think he really screwed it up,'' said James Nixon, an economist at Societe Generale SA in London. ``The market will be looking for cuts as early as Christmas at this rate.''

Oil prices have retreated 18 percent since reaching a record $147.27 a barrel on July 11 and money-supply growth, which the ECB uses as a gauge of future inflation, slowed more than economists forecast in June.

``Slowly but surely, the arguments for another interest-rate hike are running out,'' said David Milleker, chief economist at Union Investment GmbH in Frankfurt.

`No Bias'

Trichet said the ECB has ``no bias'' on interest rates. He removed a reference from his introductory statement to ``moderate, ongoing growth,'' and said the bank will have a better idea of the economic outlook when it gets new staff forecasts in September.

In June, ECB staff projected growth would slow to about 1.8 percent this year and 1.5 percent in 2009. The economy expanded 2.7 percent in 2007.

Societe Generale economists estimate gross domestic product shrank 0.5 percent in the second quarter from the first. By contrast, the U.S. economy expanded 0.5 percent in the three months through June. The Federal Reserve this week left its key rate at 2 percent.

Still, inflation in the 15-nation euro region accelerated to 4.1 percent in July as oil prices soared to a record. The ECB aims to keep the rate just below 2 percent, something it has failed to do every year since 1999.

`Strong Concern'

``The information that has become available since our previous meeting has further underpinned our decision to increase rates in July,'' Trichet said. The ECB will ``always do what is needed to deliver price stability.''

The bank raised its benchmark rate by a quarter point on July 3, citing its concern that a wage-price spiral may develop.

Negotiated wages in Germany, Europe's largest economy jumped 3.5 percent in the year through April, the biggest gain in 12 years. In Italy, wage inflation accelerated to 3.6 percent in June. Deutsche Lufthansa AG, Europe's second-largest airline, last week agreed to a 5.1 percent raise for ground workers and some cabin crew.

Inflation risks ``remain clearly on the upside and have increased over the past few months,'' Trichet said. ``There is very strong concern that price and wage-setting behavior could add to inflationary pressure.''

ECB policy makers are ``very worried about the risk of a wage-price spiral,'' said Martin van Vliet, an economist at ING Group in Amsterdam. ``They've left the door open for a rate hike this year, but I think the chances of that have diminished to below 50 percent.''

To contact the reporter on this story: Brian Swint in London at bswint@bloomberg.net. Christian Vits in Frankfurt at cvits@bloomberg.net

Last Updated: August 7, 2008 11:35 EDT