Southern European debt outperforms as ECB's Praet flags elusive inflation

* Peripheral yields lower 2-3 bps on day

* Italian 10-year yield hits 5-week low

* Italy due for ratings reviews

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

LONDON, March 16 (Reuters) - Southern European government debt outperformed their higher-rated peers on Friday as another ECB policymaker warned that inflation in the euro zone is still proving elusive, a potential hurdle to the withdrawal of monetary stimulus.

Peripheral government bonds are seen as the biggest beneficiaries of the European Central Bank's largesse, so any sense that it may prove more cautious than expected in ending quantitative easing or raising rates tends to benefit these markets.

The currency bloc may have more unexploited capacity, particularly in the labour market, which could mean that inflation might take longer to rise back to the ECB's target of almost 2 percent, the bank's chief economist Peter Praet told Reuters in an interview.

This echoes remarks made by other ECB policymakers including its chief Mario Draghi earlier this week.

"It's clear they are heading for the exit on QE but the discussion of them ending (bond) purchases in September is becoming less likely," said Marchel Alexandrovich, senior European economist at Jefferies.

"The take away for us from this week's ECB speeches is that they are starting to use the term gradualism - the idea that at a time of uncertainty the right thing to do is move slowly in terms of monetary policy. Peter Praet is putting the monetary policy spin on that," he added.

Italian, Spanish and Portuguese government bond yields dropped 2-3 basis points, falling more than the debt of better-rated peers.

Italy was the best performer - its 10-year government bond yield fell 3 bps to a five-week low of 1.94 percent.

However, this comes only after a recent underperformance against peers as investors grow concerned about the possibility that a eurosceptic government will be formed in the bloc's third largest economy.

The leader of Italy's eurosceptic League said on Wednesday a government deal with the anti-system 5-Star Movement was possible after an inconclusive election, raising the prospect of two radical groups running the country.

Traders worry this could affect Moody's and Fitch, which are due to review their credit ratings on Italy later on Friday.

"Both ratings agencies have given negative comments in the past on what happens to Italy's future if anti-establishment parties come into power, both in terms of fiscal metrics and structural reforms," said DZ Bank strategist Daniel Lenz. "It will be a close race as to whether they take ratings action."

Currently, Moody's has Italy rated at Baa2 -- just two notches above junk status -- with a negative outlook, and a downgrade is on the cards, said Lenz. Fitch rates Italy as BBB with a stable outlook, so a change to a negative outlook is the chief worry.

Other euro zone bond yields also dipped. Germany's 10-year bond yield touched a fresh five-week low of 0.57 percent.

Earlier, trading on many key European bond and stocks futures, including German Bund futures and DAX futures, were delayed as the Eurex trading system was hit by technical issues.

(Additional reporting by Dhara Rangasinghe; editing by David Stamp)