UPDATE 2-Outgoing government hikes Italy's deficit, debt targets
* Italy hikes 2013 deficit target to 2.9 pct of GDP vs 1.8 pct
* To hike debt by 20 bln euros in 2013, 20 bln in 2014
* Cuts 2013 GDP forecast to -1.3 pct vs -0.2 pct
* New targets give next government some breathing room
ROME, March 21 (Reuters) - Italy sharply hiked its fiscal deficit targets for this year on Thursday and announced it would raise debt by 40 billion euros in 2013 and 2014 to inject much-needed liquidity into its recession-hit economy.
The new targets reflect Italy's difficulties in consolidating its finances, with its debt continuing to climb despite waves of austerity measures over the last two years.
They will give some breathing space for whoever replaces outgoing technocrat Prime Minister Mario Monti following an election last month that produced no clear winner but saw voters roundly reject Monti's austerity medicine.
The main parties are deadlocked over how to form a government but they all now agree that austerity has only exacerbated Italy's problems and cannot be seen as a cure.
Vittorio Grilli, economy minister in Monti's caretaker cabinet, told reporters the economy would contract by 1.3 percent this year, compared with a previous forecast of -0.2 percent.
The 2013 fiscal deficit will come in at 2.9 percent of output, up from a previous target of 1.8 percent, Grilli said, partly reflecting the worsened economic outlook and partly to allow the payment of government debts to private firms.
The 2014 target was raised more modestly, to 1.7 percent of gross domestic product from 1.5 percent.
Last year's deficit was 3.0 percent of GDP, just inside the European Union's fiscal ceiling.
When Monti took office in November 2011 he pledged to completely eliminate the deficit in 2013.
"We will increase debt by 20 billion euros in 2013 and 20 billion euros in 2014," Grilli told a news conference.
He said he hoped the injection of liquidity would help the economy recover and thus curb potential increases in the debt to GDP ratio, which last year hit an all-time high of 127 percent, the second highest in the euro zone after Greece.
He offered no new debt to GDP target for 2013 to replace the current goal of 126.1 percent.
A government statement said this liquidity would be used to ease spending limits for local authorities, improve funding for the health service and co-finance projects sponsored by the EU.
Italy's benchmark bond yields rose briefly when the new targets were announced, with the spread compared with safer German bunds climbing to around 3.26 percentage points from 3.23, before falling back again.
Since Monti's technocrats took office at the height of the euro zone debt crisis in 2011, the government has repeatedly cut its forecasts for growth and hiked its deficit and debt targets.
The latest GDP forecast for this year also risks being over-optimistic.
When Fitch cut Italy's credit rating this month it forecast economic output would contract by 1.8 percent in 2013, and Barclays Capital and several other large banks have recently cut their forecasts to around the same level.
"I think the new GDP forecast is still behind the curve. We expect a growth contraction of around 1.7 percent," said Raj Badiani of IHS Global Insight. "We are seeing fiscal slippage and I think Italy will face a real challenge to keep the deficit below 3 percent of GDP this year."
The 2012 deficit, originally targeted at 1.6 percent, finally came in right on the EU's 3 percent limit, while the debt to GDP ratio of 127 percent was some 4 percentage points higher than originally targeted.
Grilli forecast that the economy would recovery in 2014, posting positive growth of 1.3 percent, slightly higher than the previous forecast of 1.1 percent.