*

Euro zone inflation slows to 2.2% in Aug

*

Traders firm up bets on September ECB rate cut

*

German state elections on Sunday

(Updated at 1036 GMT)

By Sruthi Shankar

Aug 30 (Reuters) - Euro zone bond yields fell across the

board on Friday as signs of cooling inflation in the bloc

cemented expectations of an interest rate cut by the European

Central Bank next month.

Data

showed

inflation in the 20 countries sharing the euro slowed to

2.2% from 2.6%, in line with expectations, as lower energy costs

pushed it closer to the ECB's 2% target after three years of

above-target price growth.

The German 10-year bond yield, the benchmark for

euro zone borrowing costs, slipped 3.0 basis points to 2.253%,

while the interest rate sensitive two-year bond yield

dipped 1.4 bps to 2.351%.

"Today's data is fully consistent with the need for

another rate cut in September," said Chris Scicluna, head of

economic research at Daiwa Capital Markets.

"But we are maintaining a view for just two more rate

cuts this year - at the September meeting and December - and

that's because the Governing Council still has a relatively

hawkish bias. It is still concerned about services inflation

being too high."

Traders were pricing in a 98% chance that the ECB will

cut rates by 25 bps next month, while the odds of another such

move in October stood at 58%. Traders overall saw rate cuts of

64 bps from the ECB the end of the year.

Separate data sets

showed

German inflation fell more than expected in August, while

French

numbers came in slightly above forecasts and

Italy's

was in-line.

Euro zone inflation is falling as predicted, easing the

risk that further rate cuts would derail disinflation, ECB board

member Isabel Schnabel said, cautioning that risks to the

outlook still remain.

Another set

showed

the number of people out of work in Germany rose

significantly less than expected in August. Still, the

seasonally adjusted job rate remained stable at 6.0%.

Investors are now awaiting the release of U.S. personal

consumption expenditures price index, the Federal Reserve's

preferred inflation gauge, at 1230 GMT (8:30 a.m. ET).

The moves in European bond markets this month have

largely been dictated by shifting U.S. rate expectations,

particularly after a much weaker-than-expected payrolls data

early in August fuelled bets of bigger rate cuts by the Fed.

While recent data has eased fears of an imminent U.S.

recession, investors will be laser focussed on incoming data to

gauge how far and fast the U.S. central bank will cut rates.

Italy's 10-year yield was lower by 3.5 basis

points​ (bps) at 3.633%, and the gap between Italian and German

bunds was at 137.4 bps.

Investors will also be watching Sunday's election in two

states in

eastern Germany

- Thuringia and Saxony - where anti-establishment parties

are performing strongly in opinion polls.