UPDATE 3-Euro zone yields pare rise after US data, remain up on higher ECB bets

(Updates prices)

By Harry Robertson and Alun John

LONDON, Sept 13 (Reuters) - Euro zone bond yields pared their rise on Wednesday following the release of U.S. inflation data, but remained up on the day after Reuters reported the European Central Bank is set to increase its inflation forecast.

Germany's 10-year bond yield, the euro zone's benchmark, was last up 2 basis points (bps) at 2.66%. It traded roughly 4 bps higher at around 2.68% in the European morning session.

The 2-year German bond yield, which is sensitive to interest rate expectations, was last 5 bps higher at 3.17%.

Data on Tuesday showed U.S. consumer price index (CPI) inflation was 3.7% on a year-on-year basis in August, up from 3.2% in July. Economists polled by Reuters had expected a reading of 3.6%.

Core inflation, which strips out food and energy, was 4.3%, down from 4.7% in July and in line with expectations.

The figures were released before the Fed's policy meeting next week. U.S. CPI inflation has dropped from a peak of 9.1% in June 2022.

"There is little in the report to convince Fed officials that they need to raise interest rates further," said Andrew Hunter, deputy chief US economist at Capital Economics.

Yields on the U.S. 10-year Treasury note - which is seen as the world's risk-free borrowing cost and influences rates around the world - dipped and were last up 2 bps at 4.28%, compared to around 4.308% before the data.

Pricing in derivatives markets suggests traders expect the U.S. central bank to keep rates on hold in the 5.25%-5.50% range and see just a 3% chance of a quarter-percentage-point hike, down from 7% earlier in the day.

Traders were also looking ahead to the ECB's policy decision on Thursday, with bond yields rising early in the European session ahead of the decision.

The rise in yields, said Jan von Gerich, chief analyst at Nordea, was the result of a Reuters report late on Tuesday which said, citing a source with direct knowledge of the matter, the ECB's quarterly projections will put inflation north of 3% next year, higher than a 3% projection in June.

That would support the case for a further rate increase, though the source said this week's rate decision was still a close call.

The yield on Italy's 10-year bond hit 4.492% just after the U.S. data was released, its highest since mid-March, before slipping. It was last at 4.458%, up 6 bps on the day.

Current market pricing reflects roughly a 63% chance the ECB will raise rates by 25 bps on Thursday, up from around a 40% chance on Monday and just 25% a week ago.

"The ECB isn't as sensitive to market expectations as say the Fed is, but it is not totally insensitive, so this kind of pricing on the margin increases the odds of hiking," von Gerich said.

"It isn't conclusive, but they do look at market expectations and worry that if they disappoint too much then you could see rates fall, and financing conditions ease, which they don't want to at the moment."

(Reporting by Harry Robertson and Alun John; Editing by Christina Fincher, Alison Williams, William Maclean and Paul Simao)