* Central bank cuts 2013 GDP view to -1.0 pct from -0.2
* Expects only 0.7 pct economic growth in 2014
* Sees 2012 budget deficit at about 3 pct of GDP
* Bad news for PM Monti, highlights challenges for next govt
By James Mackenzie
ROME, Jan 18 (Reuters) - Italy's central bank cut its forecast for the country's shrinking economy on Friday, as tight credit conditions and a gloomy international backdrop darken the domestic outlook before a national election in February.
The Bank of Italy said it now expects gross domestic product (GDP) to fall by 1.0 percent this year rather than the 0.2 percent contraction it forecast in July.
It also warned the budget deficit might not have fallen below 3 percent of output last year, which would stop Italy from exiting the EU's excessive deficit procedure, despite austerity measures imposed by technocrat Mario Monti's government.
In a quarterly economic report that highlighted the economic challenges that will face Monti's successor, the bank said the recession that started in the third quarter of 2011 would extend well into 2013, with unemployment continuing to climb and reaching 12 percent by 2014 from 8.4 percent in 2011.
Later on Friday a government official said fresh corrective measures may be needed to meet fiscal targets for this year, unless Italy's partners are flexible in allowing a deficit overshoot.
The central bank's report will be unwelcome reading for Monti, who is bidding for a second term in the Feb. 24-25 vote but whose centrist alliance lags Pier Luigi Bersani's centre-left and the centre-right led by former Prime Minister Silvio Berlusconi.
Since his appointment in November 2011, Monti has had to repeatedly cut his growth forecasts and raise his deficit and debt targets as economic conditions have weakened.
In September he raised the 2012 deficit target to 2.6 percent from 1.7 percent, and the central bank expects even that goal has been missed. Data for 2012 public finances will be issued by statistics bureau ISTAT on March 1.
Bank of Italy Governor Ignazio Visco said whichever government came to power in February would have a tough job.
"Our country must find the motivation and the incentives to decisively tackle the problem of growth," he said in a speech in Florence delivered after the report.
He called for reforms to liberalise markets, cut red tape, curb tax evasion and corruption and improve the civil justice system.
The Bank of Italy report forecast only a modest and uncertain revival in the second half of this year and growth of just 0.7 percent in 2014, and said that the economy probably contracted by 2.1 percent in 2012.
Monti, appointed at the height of the financial crisis to prevent Italy's huge public debt from sliding out of control, is widely credited with restoring international credibility, as reflected by a steep fall in its borrowing costs.
But he has overseen a severe recession exacerbated by stringent austerity measures, and election rivals delight in reeling off statistics showing the deterioration in virtually all economic indicators under his government.
Underlining the damage done to the euro zone's third largest economy since the start of the crisis, the Bank of Italy said that even after the forecast return to growth in 2014, GDP would still be almost 7 percent below the level of 2007.
The report estimated Italy's public deficit fell to "about 3 percent" of GDP in 2012, from 3.9 percent in 2011.
It gave no precise deficit estimate for the current year, when the government has forecast a balanced budget in structural, or growth-adjusted terms, but said that budget measures undertaken in 2011 would "allow an improvement in the balance of public finance in the 2013-2014 period".
It said the debt-to-GDP ratio, which the government estimates will reach 126.1 percent in 2013, would start to come down in 2014, thanks to an improvement in the primary surplus - which excludes debt servicing costs - and a return to growth.
The bank's new forecasts are significantly more pessimistic than government forecasts from October which see the economy contracting by 0.2 percent in 2013 before returning to growth of 1.1 percent in 2014.