* Italy's Monti says he will quit once budget is passed * Italian turmoil threatens contagion effect on Spain * Fed meeting on Wednesday significant for dollar By Gertrude Chavez-Dreyfuss NEW YORK, Dec 10 (Reuters) - The euro slipped against the yen and was flat versus the dollar on Monday after Italy's prime minister said he would step down early, putting the country's outlook in a state of flux and raising concerns about the euro zone's near-term prospects. Mario Monti said on Saturday he would resign once the 2013 budget passes. An election in February looks probable, with investors worried about who will navigate the euro zone's third-biggest economy out of the debt crisis. The news pushed Italy's borrowing costs higher in midday trading to 4.83 percent from 4.5 percent in the previous session. Top-ranking German bonds benefited, lifting prices and pushing 10-year yields down to 1.28 percent , from 1.29 percent late on Friday. "The interim political instability in Italy does little to shore up confidence in the euro," said Joe Manimbo, senior market analyst at Western Union Business Solutions, in Washington. The euro was down 0.1 percent on the day against the yen at 106.52 yen, falling for a third straight day. It dropped as low as 105.94 yen, its weakest in about two weeks. Against the dollar, the euro was flat at $1.2927. Euro resistance remains at the $1.2940 level, traders said, with support at $1.2885 and $1.2860. Some analysts noted that the bond and currency markets' reaction to Italy's news may have been overdone, given the fact that Monti would have called for elections in a few months time anyway. Monti's decision simply expedites the process. "Given the chaotic history of Italian politics, it is almost certain that whoever is elected prime minister will not be able to exercise anywhere near the level of control over the country's fiscal policy enjoyed by Mr. Monti," said Boris Schlossberg, managing director of FX strategy at BK Asset Management, in New York. While Italy has nearly completed its planned bond market funding for this year, the latest political turmoil could hinder its ability to borrow around 420 billion euros in 2013. There could also be an impact on neighboring Spain whose government is studying the need for outside help. Concerns about core euro-zone countries also weighed on the common currency. Germany's Bundesbank last week slashed its growth outlook for Europe's largest economy to 0.4 percent in 2013 from an early estimate of 1.6 percent. The euro was also pressured by data showing that Germany posted its narrowest trade surplus in October in more than half a year, adding to worries that the euro zone's largest economy may shrink in the fourth quarter. FED FOCUS Caution that the Federal Reserve may take fresh steps on monetary easing later this week limited the dollar's advance. The dollar index was up 0.2 percent at 80.377. Many economists expect the Fed to announce on Wednesday monthly bond purchases of $45 billion, signaling it will keep pumping money into the economy to bring down unemployment. That should be bearish for the dollar in general. Bob Lynch, global head of FX strategy at HSBC in New York, said the Fed's likely announcement of further asset purchases on Wednesday may not overly pressure the dollar as the market has already factored it in, but over the longer term, the negative effect would be more pronounced. "We view the Fed's asset purchases and the effective monetization of government debt as debasing to the dollar, undermining its reserve currency status in a manner that will ultimately be reflected in some lowering of its exchange-rate value," Lynch said. The dollar also was pressured by signs that Washington policymakers are no closer to averting the so-called fiscal cliff - tax hikes and spending cuts set to take hold next year, which analysts say could push the U.S. economy back into recession. The greenback dipped 0.1 percent for the day to 82.41 yen as traders said macro funds cut long dollar positions. Data showed speculators' net yen short positions last week rose to their highest since mid-2007. With short bets already stretched, traders said it would be difficult for the dollar to advance against the Japanese currency. But some saw a drop in the dollar as a buying opportunity. Morgan Stanley recommended buying dollars at 82.00 yen, with a stop of 81.50 yen and a target of 84.00 yen. The U.S. investment bank expects a weaker yen on the prospect of further monetary easing by the Bank of Japan after a general election next Sunday. Japan's opposition Liberal Democratic Party is expected to win. This is likely to result in more pressure on the BOJ to ease policy.