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UPDATE 2-Italy's bond yields set for biggest monthly drop since 2015

* Italian 10-year bond yields down 31 bps in Oct

* Set for biggest monthly drop since July 2015

* Sentiment boosted by ratings upgrade, ECB policy

* Spanish yields set for biggest monthly drop of 2017

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates with latest price moves, data)

LONDON, Oct 31 (Reuters) - Italy's borrowing costs were set on Tuesday to end October with their biggest monthly fall in over two years on the back of a surprise ratings upgrade, the extension of the ECB's ultra-easy monetary policy and the approval of a new electorayhgl system.

Most euro zone bond yields crept higher after data showed the euro zone economy grew faster than expected in the third quarter and unemployment fell to an almost nine-year low. Consumer inflation, however, slowed in October to 1.4 percent after two months of faster rises.

In contrast to their peers, Italian and Spanish bond yields hit fresh lows after a run of eye-popping moves in recent days.

Italy's benchmark 10-year bond yield briefly fell to a 10-month low at 1.83 percent. It is down 31 basis points this month, on track for the biggest monthly drop since July 2015, according to Tradeweb data.

That comes against a backdrop of recent positive news for Italy, the region's third-biggest economy.

Worries about a coming national election have been eased by the Italian parliament's approval of a new electoral system that is expected to handicap the anti-establishment 5-Star Movement and favour mainstream political blocs.

In addition, the European Central Bank said last week it would extend its bond-buying scheme well into next year, albeit at a reduced amount.

Italy, a key beneficiary of the ECB scheme, got another lift when Standard & Poor's unexpectedly raised its sovereign rating for Italy to BBB on Friday, its first such increase for Italy in at least three decades.

"The ECB provided the necessary backdrop, while the electoral law is important for the long-term outlook because election risk was always looming in the background for many people," said ING senior rates strategist Benjamin Schroeder. "And the ratings upgrade was the cherry on top."

Sentiment was also underpinned by easing worries about Spain as it became clear on Monday that there would be little resistance from ousted officials in Catalonia after the central government reasserted its control over official institutions in the region, which has pushed for independence.

Spanish bond yields fell to their lowest level in six weeks on Tuesday at 1.46 percent and were set for their biggest monthly falls this year.

Analysts said stability in the outlook for peripheral bond markets had encouraged carry trades, where investors borrow in low-yielding assets to invest in higher yielding ones.

"The relatively sanguine mood in bond markets is supportive for carry trades," said Kim Liu, senior fixed income strategist at ABN AMRO.

The sharp fall in peripheral bond yields this month contrasts with a fall of about 8 bps in top-rated German 10-year bond yields. That has left the gap between Italian and German bond yields at 148 bps, close to its lowest levels since December 2016. The Spanish/German yield spread is near its tightest in around five weeks.

(Reporting by Dhara Ranasinghe; Editing by Raissa Kasolowsky)