Global Daily – Scary fiscal plans in Italy

by: Aline Schuiling , Nick Kounis , Bill Diviney

Euro Politics: New Italian government-elect planning enormous fiscal measures – According to reports in the press, Italy might soon become the first European country where a government consisting of only populist parties will be formed. Indeed, negotiations between the populist Five Star Movement (M5S) and the anti-establishment Eurosceptic Lega Nord (LN) seem well advanced. Although no details about specific policy agreements have been published, some key elements of the election programmes will probably be part of the next government’s policy plans. To start with, M5S wants to support lower income groups by introducing a guaranteed income of EUR 780. Estimates of the costs of this measure range from EUR 15bn to EUR 30bn per year. On top of this, a key element of LN’s programme is the introduction of a flat tax. In its party programme, LN mentions a desired flat tax rate of 15%, but the estimates are that a flat rate of even 25% or 23% would already cost around EUR 25 or EUR 40bn per year. Finally, both M5S and LN want to dismantle the 2011 pension reform, meaning that they want to lower the pension age and raise pension payments. These changes to the pension system are estimated to cost around EUR 15-20bn per year.

Taking these three separate measures together, the total extra government expenditure or reduction in government income would be somewhere between EUR 55bn and EUR 90bn per year (equal to between 3% and 5% of GDP). Without any compensating measures, this would push Italy’s budget deficit well above the European Commission’s 3% ceiling (in 2017, the deficit was 2.3% GDP). Also, it would push Italy’s debt ratio much higher over the coming years. At almost 132% GDP Italy’s debt is already highest of all eurozone countries but Greece. As we have argued before, the current decline in the debt ratio is due only to cyclical factors and the ECB’s monetary policy measures, and Italy’s debt ratio should start rising again in the medium term, even without the expansionary fiscal plans of M5S and LN (see here).

President Mattarella could still throw sand in the wheels of M5S and LN. One of his main tasks is to guarantee that government policy complies with the constitution. As is the case in all other eurozone member states, Italy has added the clause to its constitution that the cyclically-adjusted government budget should be balanced. Although Italy has not yet met this obligation (last year, the cyclically adjusted budget balance was -1.7%), a sharp deterioration in the balance would probably not be acceptable to Mr Mattarella. He has already stated that he wants the next government to maintain Italy’s financial health and stick to the European Commission’s fiscal rules.

All the above means that that the fiscal plans are unlikely to be implemented in full, though a significant fiscal deterioration looks likely. This would mean that M5S and LN coalition will take office, but with a much less extreme policy agenda than planned. Alternatively, there could still be new elections. The first option would probably result in a unstable, short-lived government that seems prone to infighting and could also result in a loss of support for both parties because they had to drop key elements of their policy agenda. The second option, could result in M5S and LN rising in the polls and gaining even more votes in the next elections. Overall this means that the political uncertainty in Italy will continue for a considerable time. (Aline Schuiling)

ECB View: Villeroy suggests rate hikes will be quarters after QE end – The Governor of the Banque de France Francois Villeroy de Galhau triggered a sell-off in government bonds today. He suggested that the ECB would end net purchases this year and that the first interest rate hike would come ‘at least some quarters, but not years’ after that. Speaking in a Bloomberg TV interview he also confirmed that the ECB would strengthen the forward guidance on interest rates, saying it would ‘give additional guidance for … for the timing of the rate hike and the contingencies’. Mr Villeroy is generally known as a dove, though over the last year or so, his comments put him on the more hawkish end of the Governing Council spectrum. So it is unclear to what extent he represents the central tendency of his colleagues. In any case, his comments do not suggest that rate hikes are coming any time soon. Even if net purchases were to end this year, his comments suggest to us that rate hikes are still unlikely before the second half of next year. Bond markets seem to have interpreted his comments as implying a faster rate hike cycle when it eventually does come, rather than implying very early rate hikes. This was evident in the re-pricing of Euribor futures, which saw the biggest moves in 2020/2021 implied rates, with hardly any move in prices before mid-2019. Consequently, we saw yield curves generally steepen on the comments.

We continue to think that the combination of ongoing weakness in underlying inflationary pressures and uncertainty about the economic growth outlook strengthens the case for the ECB to exit at only a very slow pace. The ECB is likely to set out a clear roadmap for the end of its asset purchase programme in July. We expect a tapering period of 6 months (3 months EUR 20bn p/m and 3 months EUR 10bn p/m), meaning that net asset purchases will not end until March 2019. We do not expect the first rate hike to follow until the second half of next year (10bp in September and another 10bp in December). Furthermore, we expect the ECB to maintain or even strengthen its forward guidance on interest rates when it announces a wind-down of net asset purchases. (Nick Kounis)

Fed View: Pre-empting excessive rate hike expectations – Cleveland Fed President Loretta Mester, a voting member of the FOMC this year, spoke in prepared remarks at a Banque de France conference in Paris this morning. Her remarks were surprisingly moderate for a known hawk on the Committee. Mester continued to make the case for gradual rate hikes, warning of the dangers of allowing the economy to overheat, in particular that firms may end up hiring workers that do not match skills requirements, which tends to lead to a bigger fall in employment when the inevitable downturn happens. However, in a surprisingly dovish twist, Mester expressed doubts over the sustainability of the recent pickup in inflation, and, as with the May FOMC statement, emphasised the ‘symmetry’ of the Fed’s inflation target. This follows similar commentary from other members of the Committee last week (notably from Bostic and Kaplan, more moderate members), and appears to us to be an attempt by the Fed to caution markets against overreacting to any potential overshoot of the 2% inflation target – signaling that the Fed would be unlikely to up the pace of rate hikes to fight transitory high inflation (see also here). This supports our view that the Fed will continue hiking at a gradual, 25bp per quarter pace, and that the bar to hiking at a quicker pace than this would be a rather high one. (Bill Diviney)