UPDATE 2-Fitch cuts Italy credit rating after election impasse
* Fitch cites deeper recession, weak reform prospects
* Hikes debt forecast
* Sees economy contracting 1.8 pct this year
ROME/MILAN, March 8 (Reuters) - Ratings agency Fitch added to Italy's mounting problems on Friday by cutting its credit rating due to the political uncertainty after last week's election, deep recession and rising debt.
Fitch lowered Italy's sovereign rating by one notch to BBB plus, with a negative outlook, raising the risk that its next ratings change will be a further downgrade.
"The inconclusive results of the Italian parliamentary elections on February 24-25 make it unlikely that a stable new government can be formed in the next few weeks," Fitch said.
"The increased political uncertainty and non-conducive backdrop for further structural reform measures constitute a further adverse shock to the real economy amidst the deep recession."
The election produced a hung parliament, with a centre-left coalition winning the lower house but falling short of control of the Senate, which has equal legislative powers.
Fitch said it now expects the economy to shrink by 1.8 percent this year, far below the most recent forecast by Mario Monti's outgoing technocrat government of a 0.2 percent contraction.
Italy has been Europe's most sluggish economy for more than a decade. It has been in recession since the middle of 2011 and is not expected to post any growth until the second half of this year at the earliest. GDP shrank 2.4 percent last year.
With the economic weakness taking a heavy toll on public finances, it added that it sees Italian public debt, the second highest in the euro zone after Greece's, peaking this year at nearly 130 percent of gross domestic product.
That was a sharp upward revision from its previous forecast of 125 percent made in the middle of 2012.
The euro fell slightly against the dollar after Fitch's decision, Italian bond yields rose and the cost of insuring Italian debt against default increased.
The difference between the yield on Italian benchmark bonds and safer German Bunds closed the European trading day at 3.18 percentage points.
That was up from Friday's lows of slightly below 3 points but still far below the highs above 5.5 points at the peak of the euro zone debt crisis near the end of 2011.
Market reaction to the election has been far more muted than expected, with investors calmed by an improved global growth outlook and assurances from the European Central Bank that it will buy the bonds of euro zone countries in difficulty that ask for help.
"I don't expect the downgrade to lead to much short term pressure, but it will certainly signal that rating agencies are ready to review and worsen their view on Italy should political uncertainty continue," said ING analyst Alessandro Giansanti.
The political situation has been deadlocked since the election. The anti-establishment 5-Star Movement holds the balance of power and says it will not ally itself with either of the main centre-left and centre-right blocs.
Parliament convenes on March 15 and President Giorgio Napolitano will hold consultations with the leaders of all the parties to see if a government can be formed. If it cannot, the country will be headed for fresh elections within a few months.
"We still don't know who won the elections but we know that the country has lost," said Giacomo Vaciago, head of economic research institute REF.
Standard & Poor's rates Italy BBB-plus and Moody's rates the country Baa2. Both ratings carry negative outlooks.
With three of the four ratings agencies now rating Italy below A, the threat is increasing that investors will have to pay higher charges for using Italian sovereign debt as collateral to obtain loans from the European Central Bank.
Those charges, known as a "haircut" will kick in if the smaller Canadian agency, DBRS also downgrades Italy from its currrent A (low) rating, and would push up Italy's borrowing costs.