By Richard Leong

NEW YORK (Reuters) - News on Wednesday that inflation unexpectedly cooled in August rattled the U.S. inflation bond market where traders had bet on price increases accelerating to achieve the Federal Reserve's desired level.

The corner of the bond market linked explicitly to investors' inflation expectations sagged after a government index on domestic consumer prices unexpectedly declined for the first time in nearly 1-1/2 years.

"Today's CPI report has significantly weakened the positions of those who are hawkish," said Aaron Kohli, an interest rate strategist at BNP Paribas in New York.

Inflation break-even rates, the yield differences between U.S. Treasury Inflation Protected Securities and regular Treasury securities, shrank in reaction to a 0.2 percent fall in the Consumer Price Index last month. Analysts had forecast no change in the index.

The 10-year TIPS break-even rate fell to its lowest level in a year in advance of a $13 billion auction of this bond's maturity on Thursday.

The CPI's surprise fall came as traders had speculated whether Federal Reserve policymakers might signal intentions to begin raising its federal fund rate target in 2015.

On Wednesday, the central bank's Federal Open Market Committee retained its interest rate pledge for a "considerable time." Fed Vice Janet Yellen stressed there was still much slack in the labor market and will monitor the data closely before deciding on a "lift-off" in interest rates.

A new set of interest rate forecasts suggested Fed officials were positioning themselves for a potentially faster pace of rate hikes than they had envisioned in June, when the last set of forecasts were released.

Some analysts have said the U.S. central bank would probably not raise rates sooner, though, partly because domestic inflation, while rising this year, is still falling short of its 2 percent target on falling oil prices and slowing demand from China.

If the Fed were to raise rates even as inflation stays below its 2 percent target, "inflation expectations will have to fall further," said Richard Gilhooly, interest rate strategist at TD Securities in New York.

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The five-year inflation break-even rate was at 1.71 percent, down 9.9 basis points from late on Tuesday. TD's Gilhooly said it was the lowest since June 2013.

The yield on five-year TIPS was on track to close at 0.058 percent, which was the first time it ended above zero in a little more than a year.

The 10-year inflation break-even rate was last at 2.06 percent, down 6.4 basis points from Tuesday's close. BNP's Kohli said that was the lowest since September 2013.

TIPS have struggled recently. Barclays' index on their performance showed a 1.86 percent loss so far in September, reducing its year-to-date return to 4.34 percent.

(Reporting by Richard Leong; Editing by Lisa Von Ahn and Tom Brown)