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UPDATE 2-Rating cut piles pressure on Spain to seek aid

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* S&P cuts sovereign to 1 notch above junk, outlook negative

* Warns aid request delay a potential negative for rating

* Inflation hits 16-month high in September

* Spain banks' dependence on ECB continues

* Econ Sec says Spain still considering aid request

(Recasts, adds banks, comment)

By Paul Day and Rodrigo De Miguel

MADRID, Oct 11 (Reuters) - Spain faced renewed pressure totake the politically humiliating step of seeking sovereign aidon Thursday after a credit agency cut its rating to near junk,triggering a spike in its borrowing costs.

Standard and Poor's said the country's deepening recessionwas a factor limiting the government's options for dealing withits financial problems, adding that Madrid's reluctance to applyfor aid was a potential drag on the new rating, which it placedon a negative outlook.

Another headache for the government came with data showingconsumer prices rose at their fastest pace in 16 months inSeptember, further depressing demand among cash-strappedconsumers.

"In the short term we suspect that the noise and columninches generated by the S&P downgrade will be disproportionateto its impact," Citi said in a note.

"But the longer term impact could be very significant if themarket sees the trajectory towards Spain's eventual exclusionfrom (investment grade) indices as inevitable."

The action brought S&P into line with peer Moody's, whichalso has the country on the verge of losing its investment gradeand is due to complete a review of that rating this month.

The yield investors demand to hold Spanish benchmark 10-yeardebt rose to near 6 percent early on Thursday before dippingback to 5.85 percent, marginally up from its overnight close.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For a graphic on euro zone sovereign ratings: Spain yield curve: Debt and bond yields Economy overview ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Spain is at the centre of the euro zone debt crisis asnervous investors await a decision on European aid which wouldkick-start a bond-buying programme by the European Central Bankand bring down funding costs.

Madrid was still considering whether to apply for aid,Secretary of State for the Economy Fernando Jimenez Latorrereiterated at a conference on Thursday.

The S&P downgrade had come as a surprise and the agencywould reconsider its stance on the country's debt once it sawSpain was meeting its fiscal targets, he said.

In July, Spanish benchmark borrowing costs fell from levelsthat triggered bailouts for other euro zone states after ECBhead President Mario Draghi pledged to protect the euro.

Improved funding conditions in Spain over the last monthhave helped Spanish corporates and banks, including Santander

and BBVA , return to markets for funds andreduce reliance on the ECB for funding.

The Treasury plans a private placement of 4.86 billion euros($6.3 billion) of bonds maturing in 2015, 2016 and 2017 onThursday to finance part of a fund aimed at reducing financingcosts for Spanish regions that have been shut out of markets.

RISING PRICE PRESSURES

Spanish consumer prices rose 3.4 percent year-on-year inSeptember, according to data from the National StatisticsInstitute on Thursday that incorporated a hefty rise in salestax.

As part of the government's austerity drive, Prime MinisterMariano Rajoy increased VAT to 21 percent from 18 percent inSeptember, as well as abolishing special low rates on productsranging from cinema tickets to school supplies.

Spain must cut the public shortfall from 8.9 percent ofgross domestic product to 4.5 percent in 2013, howevereconomists fear inflation-indexed pension hikes could make thattarget impossible as prices rise.

"Indexation of pensions might challenge fiscal targets, butit is not the only risk. We are also concerned about lowergrowth and decline in employment," S&P's economists told Reutersin an email on Thursday.

With Spain facing a lengthy recession, InternationalMonetary Fund head Christine Lagarde said on Wednesday Spainshould be given more time to reduce its deficit.

The rising cost of living has placed a disproportionatelyheavy burden on a population suffering cuts to public sector payand benefits and struggling with the European Union's highestunemployment rate of 25 percent.

"The price rise is entirely due to the VAT hike, whichplaces greater pressure on wage packets in a context ofextremely weak private consumption," economist at brokerageCortal Consors, Estefania Ponte said.

($1 = 0.7751 euros)

(Reporting By Paul Day and Manuel María Ruiz; Editing by TracyRucinski, Patrick Graham and John Stonestreet)

((paul.e.day@thomsonreuters.com)(+34 91 585 83 08)(ReutersMessaging: paul.e.day.thomsonreuters.com@reuters.net))

Keywords: SPAIN ECONOMY/PRICES