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Late Monday, S&P cut Italy’s credit rating by one notch to A from A+ in light of what it sees as the country’s weakening economic growth prospects and higher-than-expected levels of government debt. Markets, which were buoyed by hopes that Greece will not be allowed to default, took the surprise move in stride. But the downgrade is likely to reinforce fears that the eurozone’s third largest economy is getting sucked into Europe’s debt crisis, which has already seen the bailout of three countries. S&P cited Premier Silvio Berlusconi’s “fragile” coalition and institutional deadlocks that have blocked reforms in saying it believed Italy was vulnerable to heightened risks. Italy’s debt burden of 120% of GDP is the second highest in the eurozone after Greece. It has carried heavy debts successfully for years because bond investors have always been willing to loan more money as bonds came due. The Federal Reserve is expected to announce a plan on Wednesday to swap shorter-maturity government securities for longer-dated ones in another stab at jolting the slow-moving U.S. economy.

Berlusconi’s office responded Tuesday by saying the evaluation “seems dictated more by behind-the-scenes reports in newspapers than reality and seems contaminated by political considerations.”  The agency dismissed Berlusconi’s criticism, saying its evaluations were apolitical and based on independent fiscal analyses. S&P warned that it may downgrade Italy again, slapping a negative outlook on its ratings. It anticipates that political differences will likely limit Italy’s ability to respond decisively to its debt crisis. The firm projects that Italy’s economy will grow at an annual average of 0.7% between this year and 2014, down from an earlier projection of 1.3 percent growth.

Bond markets began to look more skeptically at Italy after Greece, Ireland and Portugal needed bailouts and the government has had to pay more to borrow as a result. That threatens a vicious circle in which rising interest costs threaten to sink government finances and the country finds itself cut off from bond markets. In that case it either needs a bailout loan from another source or must default. The government insisted it had a solid majority in parliament, which recently passed measures to get a tighter grip on the public finances through a package of tax increases and budget cuts.

It said the government was working on growth measures, had pledged to balance the budget by 2013 and said the fruits of its growth and austerity plans “will be seen in the near-medium term.” ”What we view as the Italian government’s tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy’s economic challenges,” S&P managing director David T. Beers said. Without full confidence in the credit-worthiness of Italy, it’s impossible to have full confidence in the solvency of the European banking system. 

 ”The ratings indicate how diverse political initiatives can impact financial trustworthiness and aren’t intended to give any suggestions on the policies a government should or shouldn’t follow,” the agency said in a statement. Markets largely brushed off the downgrade as investors hoped for progress in ongoing Greek debt talks. Milan’s stock market was trading 1.2% higher, while the yield on the country’s 10-year bond was up only 0.08 percentage point at 5.61%.

 Last week, Italy’s Parliament gave final approval to the government’s austerity measures, a combination of higher taxes, pension reform and spending cuts that the government says will shave more than 54 billion ($70 billion) off Italy’s deficit over three years. The planned cuts and taxes sparked street protests in Rome similar to those in other European countries trying to come to grips with the economic crisis.  The European Central Bank had demanded stiff austerity measures to calm markets roiled for weeks over doubts about how serious Italy is about dealing with its debts. Italy is widely-considered as too big to save. The big worry in the markets is that the country will find it increasingly costly to borrow. 

Concerns that Italy might be locked out of bond markets was the main reason why the European Central Bank has splashed out billions of euros over the past month buying up Italian government bonds on the open market. Doing so has helped get Italy’s 10-year bond yield down below the 6% level, which is considered unsustainable. However, it’s started to edge higher again over the past couple of weeks as investors fret about Europe’s debt crisis spreading.

The S&P downgrade, however, could lead to higher borrowing costs for Italy because it implies that investors face greater risks when buying Italian debt. S&P said that weaker economic growth will likely limit the effectiveness of the government’s economic plan.  Italian officials have reportedly held talks with China’s sovereign wealth fund in an effort to persuade Beijing to buy Italy’s government bonds or invest in its companies. The nation’s financial crunch also has prompted Rome to consider selling stakes in major state-owned companies such as power utility Enel or oil and gas supplier Eni, according to news reports.

Fed Meeting: Operation Twist

The Federal Reserve is expected to announce a plan on Wednesday to swap shorter-maturity government securities for longer-dated ones in another stab at jolting the slow-moving U.S. economy, analysts said on the eve of a key meeting. The Federal Open Market Committee of the central bank on Tuesday starts a two-day meeting, with an interest-rate decision set for Wednesday at 2:15 p.m. Eastern. Operation Twist, dubbed by central bank officials some fifty years ago after a hit song of the era, was so named as it seeks to “twist” the yield curve.

The expectation now is that the Fed will sell debt maturing in three years or less and buy mostly 7-year to 10-year notes. In the bond market, expectations are for the program to range in size from about $200 billion to $700 billion. The program is designed to lower longer-term rates. This could help mortgage holders refinance and lower the costs of borrowing. Federal Reserve Chairman Ben Bernanke believes $200 billion of asset purchases is the equivalent of a reduction of 25 basis points in the Federal funds rate. The Fed can no longer reduce interest rates to bolster the economy, because rates already are close to zero.