Italy budget at 2.4% for each of the years 2019-2021 was at the upper end of our and markets' expectations. How will the EU respond to the rebel from the south: will they just express an opinion or will they go further, express a negative opinion, and require that Italy revise its budget? The latter would be a first and is likely to depend on the assumptions behind the budget. I believe there is a heightened risk, albeit still below 50%, that the EU will express a negative opinion on Italy.
There are a couple of points which worry me about this budget. Most importantly, it is concerning that it is a 2.4% deficit for each of the following three years, which puts Italy's debt sustainability into question. In addition, in my view the risk is that the actual budget deficits turn out to be higher than 2.4%. Finally, the budget is a blow to Finance Minister Tria's credibility.
I believe the happy days for Italy are over now and Italian debt is set to be highly volatile at least until 15 October, when we should get more clarity on the budget. I expect Italy's debt woes will have little impact on the euro, as I foresee limited contagion to other peripheral countries. The ECB saved Italy following two years of near-continuous recession from Q4 11 to Q4 13, with its cut into negative rates in June 2014 and QE in January 2015. The ECB is unlikely to save Italy this time.
Recently, there has been a lot of fuss in markets about whether the ECB is turning more hawkish following speeches from board members. In my view, the ECB is becoming more confident that wage growth is picking up, but that was already clear from Draghi's press conference earlier this month after the monetary policy meeting. I believe the ECB (and the Riksbank) are keen to take interest rates to zero when they are confident that core inflation has stabilised at slightly higher levels.
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