By Balazs Koranyi
FRANKFURT (Reuters) - The European Central Bank's policy meeting will be relegated to a sideshow next week as the wrangle over Italy's budget takes the main stage.
The Italian government is looking to boost spending in the hope of engineering faster economic growth.
But its resolve to breach European Union fiscal rules will be put to the test as it faces a rebuke from the Commission, downgrades by credit rating agencies, and a market selloff that may negate the very stimulus it has hoped for.
Italy has until Monday to explain to the Commission its breach of rules and faces the rejection of its budget, which may eventually lead to sanctions. Neither side has any incentive to back down for now.
For the Rome government, standing up to Brussels could translate into votes, while for the Commission, giving in would create a dangerous precedent that could destabilize the euro zone, especially since the bloc has already been lenient with Italy's excessive spending.
The deadlock is costly. Italian bond yields hit their highest level since early 2014 on Friday and the premium investors demand in comparison to German debt is at a five and a half year high.
This could hit the economy as Italy sits on a debt pile worth 130 percent of GDP, the second-highest debt ratio in Europe after Greece, which has just exited a bailout.
"The European process might not be central," Bank of America Merrill Lynch said in a note to clients.
"Ultimately it is the market forces, potentially triggered by the rating agencies, and the reaction of the real economy to the tightening in financial conditions, which will seal the fate of the current experiment in fiscal loosening in Italy."
Moody's and Standard and Poor's are both expected to review their Italian ratings before the month's end and downgrades to one level above junk are expected by many.
While much of this is already priced in, any commentary that would raise the prospect of a cut to 'junk' could trigger a sell off as it would carry implications from a loss off access to central bank facilities to exclusion from investor portfolios.
Yet even these apparent risks are unlikely now to force the government to back down and further escalation is likely before a compromise is found.
"So long as financial market pressures remain manageable, we find it rational for the government to stick to its strategy of maintaining tensions with EU institutions, given that it continues to pay off in terms of popularity," Barclays added.
Commerzbank said an eventual solution may be to finance more Italian spending from underutilised structural funds instead of directly burdening the budget.
Italy is also expected to be a top item for the ECB, which is all but certain to keep policy on hold on Thursday and likely put off discussion about its reinvestment policy until December.
Having already made clear that Italy's government is damaging businesses and households, ECB chief Mario Draghi is expected to repeat that no help is coming if investors start dumping Italian assets en masse.
Italian officials have suggested the ECB should use its 2.6 trillion euro bond purchases scheme, due to end in December, to support stabilise markets.
"It seems that the message needs to be made loud (er) and clear (er) that quantitative easing is part of the monetary policy framework and cannot be used to help individual national governments," BAML said.
The ECB targets an inflation rate just below 2 percent and has rejected the idea of going beyond this mandate, especially to help one particular euro area country over another.
Yet Italy's difficulties could also spell trouble for the entire bloc, which may eventually prove too difficult to ignore.
A loss of confidence could spread and drag growth, forcing the ECB to maintain stimulus longer than it hoped. With much of its firepower already exhausted from years of support, it has virtually no scope to extend its bond purchase scheme.
(Reporting by Balazs Koranyi; Editing by Angus MacSwan)