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

* 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 to take the politically humiliating step of seeking sovereign aid on 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 recession was a factor limiting the government's options for dealing with its financial problems, adding that Madrid's reluctance to apply for aid was a potential drag on the new rating, which it placed on a negative outlook.

Another headache for the government came with data showing consumer prices rose at their fastest pace in 16 months in September, further depressing demand among cash-strapped consumers.

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

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

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

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

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Spain is at the centre of the euro zone debt crisis as nervous investors await a decision on European aid which would kick-start a bond-buying programme by the European Central Bank and bring down funding costs.

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

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

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

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

and BBVA , return to markets for funds and reduce 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 on Thursday to finance part of a fund aimed at reducing financing costs for Spanish regions that have been shut out of markets.


Spanish consumer prices rose 3.4 percent year-on-year in September, according to data from the National Statistics Institute on Thursday that incorporated a hefty rise in sales tax.

As part of the government's austerity drive, Prime Minister Mariano Rajoy increased VAT to 21 percent from 18 percent in September, as well as abolishing special low rates on products ranging from cinema tickets to school supplies.

Spain must cut the public shortfall from 8.9 percent of gross domestic product to 4.5 percent in 2013, however economists fear inflation-indexed pension hikes could make that target impossible as prices rise.

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

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

The rising cost of living has placed a disproportionately heavy burden on a population suffering cuts to public sector pay and benefits and struggling with the European Union's highest unemployment rate of 25 percent.

"The price rise is entirely due to the VAT hike, which places greater pressure on wage packets in a context of extremely weak private consumption," economist at brokerage Cortal Consors, Estefania Ponte said.

($1 = 0.7751 euros)

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

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