* Letta represents generational change
* Broad coalition expected to take office in days
* Democratic Party fractured by infighting
By Barry Moody and Paolo Biondi
ROME, April 24 (Reuters) - Italian President Giorgio Napolitano on Wednesday asked centre-left politician Enrico Letta to form a new government, signalling the end of a damaging two-month stalemate since elections in the euro zone's third largest economy in February.
Letta, from the Democratic Party (PD), said he would start talks to form a broad-based coalition on Thursday. It is likely to go to parliament for a vote of confidence by early next week.
The prime minister designate is expected to select a group of ministers, likely to be a mixture of politicians and technocrats, under the guidance of Napolitano, whose own unprecedented re-election last weekend opened the way for an end to the crisis.
The new government will be backed primarily by Letta's centre-left and the centre-right People of Freedom party (PDL) led by Silvio Berlusconi, which had previously failed to reach a deal following inconclusive elections two months ago.
Rivalries between the parties as well as rifts within the PD, which fell short of a viable parliamentary majority in February's vote, could still block an accord. But formation of a government after such a long impasse would signal that Italy is finally ready to make a start on much-needed reforms.
Accepting his mandate, Letta said he would not form a government "at all costs", warning that the warring parties must make compromises or he would withdraw.
He said Italy faced an untenable situation and the government must provide answers on jobs, poverty and the crisis facing small businesses in a recession that now matches the longest since World War II.
European Union economic policies had been too focused on austerity instead of growth, he said, and Italy's parliamentary system must be reformed together with the widely criticised electoral law that has virtually guaranteed stalemate.
The bespectacled and balding Letta is an urbane moderate who speaks fluent English and at 46 would be one of Italy's youngest prime ministers, representing a generational change from the era of Berlusconi and outgoing Prime Minister Mario Monti.
A staunch pro-European and a member of the now-defunct Christian Democrat party in his youth, he is likely to be welcomed by foreign governments and markets and can also work with the centre-right.
He is the nephew of Berlusconi's longtime chief of staff, Gianni Letta, and has numerous political friends on all sides of parliament, which could help ease the fractious climate since the election.
As Letta met close aides, the names being circulated as likely future ministers suggested a government broadly in line with Monti's outgoing technocrat administration but including senior politicians such as PDL party secretary Angelino Alfano.
Bank of Italy director general Fabrizio Saccomanni was seen as a possible economy minister and Enrico Giovannini, head of statistics agency ISTAT, may take over the industry ministry. Monti himself could return as foreign minister, helping to maintain the international contacts he cultivated as premier.
Investors had already reacted with relief to the prospect of an end to the intractable crisis, with Italy's two-year borrowing costs on Wednesday tumbling to their lowest level since the start of European monetary union in 1999.
However, the country's problems are not over, with significant differences remaining between left and right over economic policy and the centre-left in disarray after letting slip an election it had once seemed sure to win.
These difficulties were put into sharp focus even before Letta was chosen, when Renato Brunetta, a senior member of Berlusconi's PDL party, said they would only support a government committed to repealing, and refunding, a housing tax introduced by Monti.
The centre-left agrees only to a partial reduction of the tax and many economists say cuts in the levy would leave a gaping hole in Italy's public accounts.
Letta will also have to make sure he has his own party behind him. Factional infighting forced Pier Luigi Bersani to resign as party leader last week and there is significant internal opposition to any accord with Berlusconi.
Matteo Renzi, the ambitious young mayor of Florence seen as a potential leader of the centre-left, could also prove a difficult partner to integrate.
Berlusconi gave a firm promise to Napolitano that he would support a coalition government in which his party shared power with the PD but favourable opinion polls may tempt him at some point to seek new elections.
Napolitano, who reluctantly agreed to serve another term as president, has made clear, however, that he will not accept endless squabbling between the parties and has threatened to resign if they do not unite behind economic and constitutional reforms.