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Italy tempers deficit plan

By David Morrison  |  03/10/2018 14:53

The euro rallied initially after the Italian coalition government lowered its budget deficit targets. Meanwhile, Fed Chairman Powell sees little threat of inflation from low unemployment

The euro rallied today, along with European stock indices, lifted by news that the Italian coalition government may roll back its high deficit spending plans. Italian equities and government bonds had slumped after the Northern League/5-Star coalition announced last week that it was preparing to boost its budget deficit to 2.4% of GDP for the next three years to implement spending programmes promised during the General Election back in March.

But in proposing its budget plan, the government faces a showdown with the European Commission (EC). The previous Italian administration had promised the EC it would reduce spending and raise taxes to help address Italy’s crippling debt burden. The Commission is insisting that Italy progressively cut its fiscal gap to trim its troublesome debt.
But overnight the Italian newspaper Corriere della Sera reported that a revised draft budget will aim for a deficit of 2.4% next year, then 2.2% in 2020 coming down to 2.0% in 2021. The hope is the coalition is seen as honouring its election promises, while softening its two-fingered approach to dealing with the European Commission.

But this may not be enough. If the EC pushes for more, then we’re set for a showdown. My guess is Italy’s coalition won’t back down further. After all, other EU members, including Germany and France, have run rule-breaking budget deficits without punishment. Yet Italy’s high debt levels present a real problem for the European Union, particularly if yields on the country’s government bonds blow out further, raising the risk of an unmanageable rise in borrowing costs, which would threaten a default without European Central Bank intervention.

This is one of the reasons that this morning’s rally in the EURUSD wasn’t sustained. Another reason was last night’s speech from Fed Chairman Jerome Powell, the first time we’ve heard from him since last week’s Fed rate hike.

Mr Powell was upbeat about the US’s economic outlook. In this he was echoing a bullish set of FOMC economic projections from the FOMC. While the accompanying Fed statement surprised analysts by its omission that monetary policy would remain “accommodative”, the Chairman went to great lengths to explain that this term was no longer helpful, and that monetary policy was still far from being restrictive.

Last night’s key takeaway was that the Fed really isn’t worried about inflation. The central bank is convinced that low unemployment won’t spur price rises, that wage growth alone need not be inflationary and that the labour market is not overheating.  Mr Powell noted the “…Historically rare pairing of steady, low inflation and very low unemployment testament to living in extraordinary times.” But even if inflation should pick up, the Fed has said there’s been long periods with inflation below its 2.0% “symmetric” target, so it would be comfortable with an overshoot.

This has implications for Friday’s Non-Farm Payroll report, and specifically the data on Average Hourly Earnings. At +2.9% year-on-year, this came in well above expectations last month, leading observers to worry that it would feed through to inflation and cause the Fed to raise rates more aggressively than forecast. Bear in mind that a similar jump back in February was blamed for a sharp spike in volatility and a 10% correction across the major US stock indices. But if the market really believes the Fed is relaxed about wage growth, it would seem unlikely that further jump in hourly earnings will lead to another stock market rout. Maybe so. But it’s fair to say that US stock markets have pretty much ignored all bad news for most of this year while the bull market is looking long in the tooth. That’s not to say equities can’t continue to rally from here. But at some time in the future central bank tightening will remove sufficient liquidity for stock market bulls to pull in their horns and look for safer havens.
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