By Joe Ortiz and Stella Dawson

MADRID/FRANKFURT, Mar 29 (Reuters) A European Central Bank policymaker warned on Wednesday of inflationary risks, and another said the ECB must match its rhetoric with action, adding to market expectations of an interest rate rise in May.

Their hawkish comments fuelled a steep sell-off in European government debt futures, while money markets now see a higher than 90 per cent chance that the ECB will increase its key interest rate for a third time in May, as well as a slight risk of a rise next week.

ECB policymakers did nothing to dispel these expectations.

''There are risks to price stability and among those are second-round effects,'' ECB Executive Board member Jose Manuel Gonzalez-Paramo told reporters in Madrid.

''The ECB is concerned principally about price stability, and if monetary aggregates showed dynamic growth and if asset prices rise, that would be a concern,'' he said.

Market expectations of a rate rise from 2.5 per cent on May 4 have risen rapidly since data on Tuesday showed M3 money supply growth accelerated to an annual rate of 8 per cent in February -- way above the ECB's 4.5 per cent reference level -- and that mortgage lending hit its highest level in over six years.

German business confidence surging to a 15-year high has also bolstered the view that the ECB refinancing rate would soon rise a quarter percentage point to 2.75 per cent.

A Reuters poll released on Wednesday showed 63 economists giving a 67.5 per cent chance that the ECB Governing Council would raise rates in May. It next meets on April 6.

U.S. Federal Reserve warnings of inflationary dangers overnight also fed the view that credit tightening by major central banks will continue and may even quicken.

''As the prospects for higher U.S. rates loom larger, there have been more indications from other ECB officials that policy may soon get adjusted,'' said Barclays Capital chief European economist Julian Callow.

MAY RISE? Asked about expectations of a May move, ECB Executive Board member Lorenzo Bini Smaghi said: ''Financial market participants know by now quite well the objective and the strategy of the ECB.'' ''They can set their expectations about future interest rates on the basis of this framework on the flow of information on economic developments in the euro zone and on the communication that the ECB regularly makes,'' he said in a Financial Times interview published on Wednesday.

Bini Smaghi was interviewed on Monday and confirmed his comments on Tuesday after release of the money supply numbers and the German Ifo survey showing strong business confidence.

Luxembourg central bank governor Yves Mersch was more explicit. Though he declined to speculate on May, he told the International Herald Tribune that the ECB's work was not done.

''Where we still have to walk the talk is to deliver on price stability to bring about inflation that is close to but below 2 per cent,'' he was quoted as saying in an interview conducted on Monday and published on Wednesday. ''That is also part of walking the talk, to be faithful to what we say.'' Mersch used the same phrase of ''walk the talk'' just before the ECB raised its benchmark rate in December for the first time in five years.

He also noted some signs of second-round inflation where the surge in oil prices is feeding broadly into wages and prices.n ''We are beginning to see a certain impact of indirect price rises,'' Mersch said.

The ECB has consistently urged businesses and labour unions to refrain from higher prices and wages to offset the oil spike.

In Germany, where wage restraint has dominated for years, the huge engineering union IG Metall staged temporary walkouts on Wednesday. Its 3.2 million workers are demanding a 5 per cent pay rise. Meanwhile in France, young people have taken to the streets to protest plans to cut job protections for youth.

In his interview, Bini Smaghi said labour market flexibility is what's needed in the euro zone and productivity must be lifted so that wage compensation can be higher.

Gonzalez-Paramo was positive on the growth outlook following strong data this week but he noted inflationary risks.

''The predictions of a recovery are being confirmed but we are still seeing high oil prices and global imbalances,'' he said when asked if the ECB was worried about economic fragility.

Meanwhile Otmar Issing, the ECB's chief economist, told the German magazine Capital that anchoring inflationary expectations at a low level is key to credibility of the euro currency.

REUTERS SD HT1908