LONDON, Sept 28 (Reuters) - Italian yields surged on Thursday after the Italian government cut its growth forecasts for this year and next and hiked its budget deficit targets, while Germany's 10-year yield hit a fresh 12-year high ahead of Germany's inflation data for September.

The deteriorating outlook for the Italian economy poses a tough challenge for Prime Minister Giorgia Meloni, who must find a way to finance tax cuts promised in the 2024 budget to be presented next month without risking a sell-off of Italian debt.

Italy's 10 year yield rose 12.2 basis points (bps) to 4.89%, to a one year high.

Germany's 10-year bond yield was last up 8.7 bps at 2.92% after hitting its highest level since July 2011, with investors closely watching consumer price index (CPI) data in Germany, with the national figure due at 1200 GMT, ahead of the euro zone inflation numbers on Friday.

Inflation data could give investors more clues on whether the European Central Bank (ECB) will pause its monetary tightening cycle, after it raised its key interest rate to a record high of 4% in September but, with the euro zone economy in the doldrums, signalled that the hike was likely to be its last.

The gap between Italian and German 10-year yields reached 197 bps, its widest since March.

Althea Spinozzi, Saxo Senior Fixed Income Strategist, said that she is closely watching the spread.

"The underperformance of BTPs is linked to yesterday's fiscal budget in Italy... I am closely monitoring the BTP/Bund spread because whenever it breaks above 200bps, and sustains above this level for a while, it becomes a political problem for both the ECB - because it doesn't want to tighten financial conditions more in Italy than elsewhere - and for the Italian government," Spinozzi said.

Higher costs of borrowing could lead to political instability in Italy, she added.

Inflation data from German states, released this morning and used to calculate a preliminary figure for Germany, showed a mixed picture for price growth across the country.

"If (Germany's CPI) surprises on the downside, it might be a reason for European sovereign yields to stop their rise. Yet, the real test will come when the U.S. market opens and if yields continue to rise there," Spinozzi said.

In the meantime, five economic institutes are predicting gross domestic product (GDP) in Germany will contract by 0.6% in 2023, as rising interest rates take their toll on the economy and high inflation depresses consumption in the euro zone's largest economy.

(Reporting by Joice Alves Editing by Ros Russell)