Euro zone weighs action to stem market contagion from Italy: ECB's Praet

LONDON (Reuters) - Euro zone policymakers have discussed using the bloc's bailout fund to stem any contagion from Italy's debt woes to other indebted countries, the European Central Bank's chief economist said.

The Italian government has seen its borrowing costs surge since it proposed a budget that would increase its deficit, setting it on a collision course with the European Commission over budget rules and stoking fears of a new debt crisis in the euro zone.

The ECB's Peter Praet said this was starting to have some effect on financing in Greece, and euro zone policymakers were weighing tapping the European Stability Mechanism (ESM) if there were further contagion.

"There is one discussion, which is at the political level, about precautionary measures we could take if there would be spillovers to (other) countries," Praet told an audience in London on Tuesday.

"(These are) not central bank measures. It is related to the ESM and to countries ... having spillovers to some external events."

Investors have been trying to gauge whether tighter financing conditions in Italy could derail the ECB's plans to stop adding to its 2.6 trillion-euro pile of bonds at the end of this year and raise rates at some point after next summer.

But Praet said it was a government's job to keep its creditors on side.

"Other factors such as economic fundamentals and the creditworthiness of issuers, as assessed by market participants, remain key determinants of the levels of bond yields and spreads," he said.

He also backed analyst expectations for the first ECB rate hike since 2011 to come late next year and predicted higher long-term bond yields as the central bank's portfolio aged and its effect on the market waned.

But he cautioned the ECB's policy would remain predictable and only be tightened gradually.

"Our policy will remain predictable, and we will proceed at a gradual pace that is most appropriate for inflation convergence to consolidate," Praet said.

(Reporting By Marc Jones; writing by Francesco Canepa in Frankfurt; editing by Balazs Koranyi, Andrew Heavens and Larry King)