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* Spanish CPI pushes peripheral bond yields to new lows
* Expectations of further ECB easing growing
* Italian 10-year auction yield lowest since Oct. 2005 (Updates with Italian auction results)
By Marius Zaharia
LONDON, March 28 (Reuters) - Spanish, Italian, Portuguese and Irish bond yields fell to new historical lows on Friday as an unexpected drop in Spanish inflation bolstered expectations the European Central Bank could ease monetary policy further.
Italy's cost of borrowing over 10 years fell to its lowest since October 2005 at a Friday auction. It raised the top end of its larger-than-usual 7.5-10 billion euros target.
With some market participants betting that eventually the ECB may even begin to print money via asset purchases, yields on top-rated debt are pinned at ultra-low levels, prompting investors to look down the ratings scale to maximise returns.
The soft inflation data has increased speculation that the ECB may at least give clearer hints on how much it is prepared to loosen monetary strings at its monthly meeting next Thursday.
Data showed on Friday that Spanish consumer prices were down 0.2 percent year-on-year in March, compared with a previous reading of 0.0 percent and a Reuters poll forecast of a 0.1 percent rise.
That led to expectations that inflation for the whole euro zone, due on Monday, could fall even below the 0.6 percent Reuters consensus. The ECB's target is just below 2.0 percent.
"Investors are pricing in a more dovish ECB given the low inflation data ... they continue to crave for yield," DZ Bank strategist Christian Lenk said.
Italian 10-year bond yields fell to their lowest in 8-1/2 years at 3.261 percent, before rebounding to 3.30 percent as dealers sold some of the bonds they bought at the auction back to the market.
There will be a further pointer on euro zone inflation from German data due at 1300 GMT. A 1.0 percent rise is expected.
Spanish 10-year yields also hit their lowest in eight years at 3.2 percent, while Irish yields dipped to a new record low of 2.974 percent, according to Reuters data.
"Investors are transfixed by inflation and monetary developments in the euro zone," said Luca Jellinek, European head of fixed income at Credit Agricole. "An increasing portion of the market is betting that the increasing stream of hints and comments on ... (asset purchases) by the ECB will result in some bond-friendly action."
Portuguese 10-year yields fell faster than most of their euro zone peers to touch levels below 4 percent for the first time in four years, as investors grew more confident it will make a clean exit from its bailout programme in May.
Rabobank strategists recommended investors buy Portuguese debt against German Bunds, targeting a 200-basis-point gap between the 10-year yields of the two issuers, versus roughly 250 bps on Friday.
At the height of the crisis, the premium Portuguese bonds offered over Bunds, the benchmark for euro zone borrowing costs, was more than 1,500 bps.
"Approaching the exit of the bailout is sufficient to drive Portuguese yields further down," DZ Bank's Lenk said. (Editing by Catherine Evans)