UPDATE 2-Czech inflation near 1-1/2-yr low,tames rate bets

(Adds c.bank comment in paras 6-8, bond auction in para 17)

By Marek Petrus

PRAGUE, Nov 8 (Reuters) - A cut in regulated gas costs squeezed Czech annual inflation close to a 1-1/2-year low in October, prompting financial markets to look for a delay in further interest rate hikes until next year.

The consumer price index (CPI), the inflation gauge targeted by the central bank (CNB), fell by 0.5 percent in October from September, exceeding the median forecast of a 0.2 percent drop in a Reuters poll of analysts.

Annual inflation eased to 1.3 percent, its lowest since May 2005, from 2.7 percent a month ago, statistics office data showed. The drop undershot even the lowest 1.5 percent forecast in the Reuters poll.

"The base effect of falling natural gas prices is the main driver behind such a steep fall in inflation," said Miroslav Plojhar, chief analyst at Citibank in Prague.

Natural gas prices for households, set by the energy-market regulator, fell 5.5 percent following their jump last year.

The CNB said the CPI drop was unexpectedly sharp, with the annual rate falling through the bottom of its rolling target, which is to keep price growth within a plus/minus 1 percentage point band around a 3 percent mid-point.

"The deviation from the (CNB's) prediction was to the same degree caused by the development of food prices and so-called adjusted inflation excluding fuel prices," said Tomas Holub, head of the central bank's monetary and statistics department.

The CNB prefers to look at the adjusted rate -- net of tax and administrative price increases as well as volatile food and fuel prices -- to track the underlying trends in inflation.

The low inflation reading, coupled with this month's 1 percent rally in the crown currency, sent debt yields and money market rates lower on expectations the CNB would resume policy tightening only early next year.

"With CPI inflation less than half the 3.0 percent target, the central bank is likely to keep rates on hold in coming months, and let any crown appreciation do the tightening work," said Olivier Desbarres, economist at Credit Suisse in London.

A firming currency tends to keeps a lid on import prices in the small and very open Czech economy, helping offset budding demand-pull pressure on prices from robust economic growth which has been increasingly propelled by consumer spending.

BOTTOMING OUT

Additional credit tightening remained on the cards, as economists agreed inflation had bottomed out in October and would creep back up above 3 percent in early 2007 because of hikes in tax and regulated prices and a further demand revival.

Policymakers last raised the key rate by 25 basis points to 2.50 percent in September, adding to two earlier hikes lifting borrowing costs from last year's record low of 1.75 percent.

The gap between Czech and benchmark euro zone policy rates will widen to an all-time high of 100 basis points next month, if the CNB stands pat and the European Central Bank increases its main rate to 3.50 percent as markets currently forecast.

"This should continue to work against crown appreciation, but the Czech macro story is potent enough to attract foreign exchange inflows," said Credit Suisse's Desbarres.

The crown held largely steady at 28.020 per euro <0#EURCZK=> by 1210 GMT, off a lifetime high of 27.875 posted on Monday but up nearly 5 percent over a year ago.

Fading bets on another CNB rate hike in December spurred investor interest for fixed-income debt, with the government receiving bids worth more than treble the amount of paper on offer in an auction of 4-year government bonds [ID:nL08912492].

((For INSTANT VIEW of October CPI data, click on [ID:nL08197555])) ((Editing by Ron Askew; Reuters Messaging: rm://marek.petrus.reuters.com@reuters.net; e-mail: prague.newsroom@reuters.com or marek.petrus@reuters.com; Tel: +420 224 190 477))

Keywords: ECONOMY CZECH INFLATION