FRANKFURT (Reuters) - The European Central Bank kept interest rates unchanged yesterday but discussed a cut as financial market turmoil and slowing economic growth has caused inflation risks to ease, ECB president Jean-Claude Trichet said.

"With the weakening of demand, upside risks to price stability have diminished somewhat, but they have not disappeared," Trichet told his monthly news conference.

Markets took Trichet's words as a signal that the ECB was readying to cut rates in the next few months, although Trichet said that policymakers were unanimous in wanting to keep them on hold this month.

"Whatever doubt there was about December and March ECB rate cuts is now gone," said interest rate strategist Sean Maloney from Nomura.

Trichet declined to comment on the market reaction to his remarks.

The ECB raised interest rates to their current seven-year high of 4.25 percent as recently as July. Trichet said the ECB's decision to do so had helped the bank to regain control of market inflation expectations, which had risen as inflation surged to a record four percent in July and August.

But since then, financial markets have taken a sharp turn for the worse, with the collapse of US investment bank Lehman Brothers in September sparking a wave of bank rescues in Europe and the United States.

Euro zone inflation has also fallen to 3.6 percent, though it remains well above the ECB's target of just below two percent.

Trichet said ECB policymakers recognised "the extraordinary high level of uncertainty stemming from latest developments" on turbulent financial markets and the credit crunch.

"Economic activity in the euro area is weakening with contracting domestic demand and tighter financing conditions," he said.

Responding to reporters' questions, Trichet said the Governing Council had discussed cutting interest rates at its monthly policy meeting yesterday.

"To make our decision we had examined two options — to keep interest rates unchanged; the other one (was) decreasing interest rates," he said. "Our conclusion is that we were right in keeping interest rates as they are."

All 81 analysts polled by Reuters last week had expected the ECB to keep rates at a 7-year high of 4.25 percent for the third month in a row, due to its concerns about above-target inflation.

Euro zone government bond futures briefly hit a session high on Thursday and interest rate futures leapt by up to 10 basis points across the 2009 strip after Trichet said inflation risks had diminished.