Tax rise drives Spanish inflation to 16-month high

Spanish consumer prices rose at their fastest pace in 16 months in September, data showed on Thursday, one more headache for Madrid after ratings agency S&P downgraded its sovereign debt to one notch above junk overnight.

Prices rose 3.4 percent year-on-year in September, according to data from the National Statistics Institute on Thursday, after a 3-percentage-point rise in Value Added Tax on September 1.

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Spain's 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 as part of an austerity drive.

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.

Rising costs of goods are also another burden for a population struggling with the European Union's highest unemployment and cuts in public sector pay and benefits, while facing years of austerity and a barren economy.

"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.

Standard and Poor's cited deepening recession in Spain as a key factor limiting the government's options to deal with its financial problems.

The rating cut, which brings S&P in line with Moody's by placing the country on the verge of losing investment grade, pushed the yield investors demand to hold Spanish 10-year debt to near 6 percent on Thursday.

Moody's is due to decide on its own Spanish sovereign rating grade sometime in October.

September's national inflation compared to 2.7 percent in August and a Reuters poll forecast of 3.5 percent.

Spanish European Union-harmonized prices rose 3.5 percent from a year earlier, up from 2.7 percent in August and in line with the Reuters forecast.

Core inflation, which strips out volatile food and energy prices, was 2.1 percent year on year, compared to a reading of 1.4 percent a month earlier.

(Reporting By Paul Day and Manuel Mar��a Ruiz; Editing by Tracy Rucinski and Patrick Graham)