(Adds government, analyst comment)
By Paul Day and Andrew Hay
MADRID, March 12 (Reuters) - Spanish inflation fell to 0.7 percent in February, its lowest since 1969 as retailers held down prices amid Spain's worst recession in at least half a century, but the country should avoid a deflationary spiral.
Year-on-year inflation eased from 0.8 percent in January as expected, with clothing shops offering steep discounts and hotels and bars cutting prices to lure customers spooked by the fastest rising unemployment of any OECD country, National Statistics Institute data showed on Thursday.
Spanish core inflation, which discounts volatile food and energy components, fell to a lower-than-expected 1.6 percent in February from 2 percent the previous month.
That showed prices were falling rapidly across the wider economy as it faced what Spain's second largest bank BBVA fears could be the worst recession since the 1936-1939 Civil War, with a 2.8 percent decline in 2009 gross domestic product.
"What concerns us is as headline inflation goes into negative territory later in the year, if this is enforced by lower than expected core inflation it could lead us into the territory of deflation," said UBS economist Stephane Deo.
Spanish Economy Secretary David Vegara saw no such risk and expected inflation to dip into negative territory for a few months.
"I don't in any way see deflation ahead of us," Vegara said during a press conference.
February data showed Castilla La Mancha was the first Spanish region to report negative inflation of -0.1 percent.
Economist Xavier Segura saw headline inflation turning negative in May and staying there until September with little risk of deflation.
"The lowest point should be July, with a fall of around 1.1 percent," said Segura of Caixa Catalunya, who saw year-on-year inflation picking up to 1.4 percent by year end. "Deflation is defined as a prolonged period of negative inflation, but this is just going to be a passing phase."
Spain has traditionally had one of the euro zone's highest rates of inflation due to the low competitiveness of its service sector and high reliance on imported energy and raw materials.
But Spanish consumer price growth fell below the euro zone rate last year, expanding its differential to 0.5 of a percentage point in February, as domestic demand crumbled after industrial production fell by the highest rate on record in January.
Spain's Funcas savings bank consultancy saw headline inflation at a low of -1.3 percent in July before ending the year at 1.1 percent and rising to 2 percent in 2010.
Funcas saw core inflation staying positive for the rest of 2009 before rising to an around 2 percent in 2010.
Vegara said Spaniards should have no fear of deflation while core inflation stayed out of negative territory. (Reporting by Andrew Hay, Paul Day, Manolo Ruiz; editing by Toby Chopra)