Ignazio Visco: Italy and the euro area in difficult and uncertain times
Remarks by Mr Ignazio Visco, Governor of the Bank of Italy, at the Official Monetary
and Financial Institutions Forum (OMFIF) virtual dialogue, 3 November 2022.
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Let me thank David for his kind invitation and the Official Monetary and Financial
Institutions Forum for organising this event. In these opening remarks, I will
provide a brief overview of the outlook for the Italian economy and discuss my
views on the current and future stance of monetary policy.
I think it is useful to start with an assessment of the global economic prospects. In
recent months, two main well-known facts are characterising the international
economic and financial situation.
First, uncertainty is growing considerably, as it is increasingly evident that the
global economy is being heavily affected by the consequences of Russia's
aggression in Ukraine. The most obvious repercussions are being observed on
the energy market. The price of the gas delivered in Europe, in particular, has
recorded unprecedented fluctuations for about a year, rising to 340 euros per
megawatt hour two months ago, from less than 20 euros at the beginning of 2021.
Since the end of August, as European countries have achieved their storage
targets, it has fallen back up to around 100 euros. Futures prices, however,
suggest that it will remain high for the whole of next year. Food prices on world
markets have also been hit, even though tensions eased somewhat after the
agreement between Russia and Ukraine at the end of July, which unlocked grain
deliveries from the Black Sea ports. The unilateral suspension of this agreement
decided by Russia in the last few days provides a further, dramatic confirmation of
the great uncertainty connected with the developments of the conflict in Ukraine.
Second, inflation is surging rapidly. Globally, it has risen from less than 5 per cent
in 2021 to around 9 per cent this year. In response to these pressures, in almost
all advanced countries and in many emerging and developing economies, central
banks have begun to tighten monetary conditions in order to counter the increase
in current and expected inflation, and the possible start of a spiral between prices
and wages.
As a consequence of these two facts, growth prospects are recording a
widespread worsening. According to the last projections by the International
Monetary Fund (IMF), the growth rate of the global economy will decrease from
the 3.2 per cent estimated for this year to 2.7 per cent in 2023, almost a
percentage point lower than was expected last April. Despite these deteriorating
prospects, however, aggregate demand is holding up. In Italy we can actually
observe a better-than-expected resilience, for example in the service sector, also
thanks to the continuing recovery of tourism flows, and in the labour market.
In this highly uncertain framework, the Bank of Italy's latest Economic Bulletin
presented two projection scenarios for the Italian economy. The first assumes that
gas flows from Russia to Italy remain on average at the levels observed in recent
months and that the prices of raw materials are in line with those of recent futures
contracts. In this scenario, GDP growth would fall from close to 3.5 per cent in
2022 to less than 0.5 per cent in 2023. GDP, in particular, would decline in the last
quarter of this year, and then gradually recover from the second quarter of 2023.
The weakness of economic activity would reflect both that of consumption - which
would diminish, following the decrease in the purchasing power of households -
and that of investments in machinery and equipment - which would decelerate
due to high uncertainty and the increase in financing costs. The worsening of
international trade would also have an impact, as real exports would grow much
more slowly after increasing at a rate of more than 10 per cent, both in 2021 and
2022.
The second, more adverse scenario, assumes that energy supplies from Russia
to Europe are permanently shut off starting in the final quarter of this year and are
gradually, albeit only partially, replaced with alternative sources next year; oil and
gas prices are therefore projected to rise to around 50 per cent more than was
contemplated in the first scenario. These developments would be accompanied by
a further slowdown in world trade and a sharp rise in uncertainty. In this case,
Italian GDP would fall by over 1.5 per cent next year, while inflation would exceed
9 per cent, 2.5 percentage points more than in the first scenario.
Both of these scenarios were drawn up before the publication, earlier this week, of
Italy's GDP growth in the third quarter, which was substantially better than
expected (an increase of 0.5 per cent quarter-on-quarter, against widely held
expectations of a negative figure). These new data suggest that growth should,
ceteris paribus, be somewhat higher this year and this effect would mechanically
carry on to the next year.
These new relatively surprising data confirm that, in a difficult context like the
current one, macroeconomic projections, albeit detailed like those referring to
these two scenarios, are to be intended as purely indicative and are closely linked
to the assumptions on prices and availability of raw materials, which are, in turn,
largely determined by developments in the conflict in Ukraine. In any case, the
risks for economic growth are still tilted downwards. They stem from geopolitical
tensions as well as from the outlook for other economies, first and foremost the
US economy, where, also due to the strong tightening of monetary conditions,
many indicators suggest a possible contraction in economic activity in the next 12
months. Further negative effects could derive from a potentially sharp slowdown
in China, mainly connected with the fragility of the construction sector. The
persistence of inflation at high levels for longer than currently expected would
obviously be a further negative risk for the purchasing power of households'
incomes.
Despite the worsening outlook, Italy's debt-to-GDP ratio continues to improve. It is
currently estimated at around 145 per cent in 2022, 5 percentage points less than
in 2021 and 10 points less than the peak achieved in 2020: about half of the
increase recorded due to the pandemics has therefore been recovered. Over the
next three years, the debt-to-GDP ratio should continue to fall, although likely at a
more moderate pace.
Several factors will affect the future dynamics of public debt. General government
net borrowing is currently projected on a descending path. In the latest
assessment by the Italian Ministry of Economics and Finance, it would settle at
about 5 per cent of GDP this year and just above 3 per cent next year (against
over 7 per cent in 2021 and 9.5 per cent in 2020). The increase in yields on
government securities will raise debt-servicing costs in nominal terms. However,
the high average residual maturity of the debt (close to 8 years) will slow the
transmission of higher interest rates to debt servicing costs. For example, this
year the average cost of debt has remained quite stable, at 2.5 per cent, despite
yields rising from less than 0.5 per cent to above 3 per cent for 10-year bonds.
Due to the necessary normalisation of monetary conditions in the euro area, the
cost of debt servicing is set to increase further. It is worth pointing out that as
interest rates are rising to contrast the growth in inflation, this would not worsen
servicing costs in real terms insofar as real interest rates will not substantially
move up in the medium term. Indeed, the rise in prices would push up the
denominator of the debt-to-GDP ratio, an effect that is currently dominating the
dynamics.
It is nevertheless important to outline a realistic path for continuing the gradual
recovery in the high levels of public debt to GDP that started last year. It would be
an important signal of credibility for financial markets, which could translate into
lower sovereign risk premiums. The budgetary margins that will become available
and those created with the moderation of the dynamics of other expenses will
make it possible to provide financial support to the economy. Temporary and
targeted support, with interventions aimed at households and firms in greater
difficulty, will not compromise the state of the public finances and will also help to
contain pressures on inflation.
Let me now turn on the euro area. In its latest projections, released in early
September, the ECB revised GDP growth estimates to 0.9 per cent in 2023, from
3.1 per cent in 2022; with a month of additional data, the IMF has revised them
down to 0.5 per cent, signalling a substantial halt. Consumer price developments
are no less concerning: inflation rose to 10.7 per cent in October. Net of energy
and food, the most volatile components, core inflation rose to 5.0 per cent. More
than 60 per cent of the increase in consumer prices recorded in the last twelve
months has been caused, directly and through the effects on production costs, by
the increases in energy prices. This share rises to almost 80 per cent if we also
take into account the effects of food prices not relating to energy, but which have
also been affected by the conflict in Ukraine.
The growth of consumer prices in the euro area is projected to be above 8 per
cent on average in 2022; it would then gradually fall to below 6 per cent over the
course of next year and converge towards a value close to the ECB's 2 per cent
target in the second half of 2024. Expectations derived from the prices of
inflationlinked swaps as well as those based on surveys carried out in October, such as
those conducted by the ECB on monetary analysts or those of other private
institutions, provide a similar picture. The expectations of households, as
suggested by the ECB survey, display slightly higher values: 5 per cent by the end
of 2023 and 3 per cent over a 3-year horizon. This could reflect not only a greater
weight of backward-looking elements in the formation of households'
expectations, but also the large weight of the most volatile components of inflation
in the consumer basket of less well-off households.
Wage dynamics in Italy and in the euro area have so far remained contained. In
our country, the growth trend in contractual wages was less than 1 per cent in the
second quarter, 0.3 percentage points more than at the beginning of the year,
mainly due to the renewal of contracts in the public sector. Net of one-off
components, contractual wages accelerated on average for the area in the
second quarter, to 2.5 per cent. The growth in labour costs could intensify in the
final part of this year and in 2023, due to the increase in the minimum wage in
some countries and those that will likely be granted to contain the loss of
purchasing power of workers' incomes. However, the marked weakening of
economic activity and the modest share of inflation-linked wages in the area as a
whole may limit, as of now, the risks of a spiral between prices and wages.
Last Thursday, the ECB Governing Council raised official interest rates by 0.75
percentage points, bringing the overall increase since 21 July to 2 points. In this
way, a substantial step forward was taken in the reabsorption of monetary
accommodation, driving the rate on banks' deposits with the Eurosystem a long
way from the negative levels that had been necessary to hinder the risk of
deflation and limit the fallout of the pandemic crisis. Based on market participants'
expectations, one-year real rates are still very low and would barely become
positive by the end of next year.
The decision to modify the terms and conditions of the third series of targeted
longer-term refinancing operations (TLTRO-III) was justified by the need to ensure
that the contribution of this instrument is also consistent with the broader
normalisation process of monetary policy. The recalibration intends to strengthen
the transmission of official rate increases to the conditions of bank loans and to
remove the constraints on the process of reducing the Eurosystem's balance
sheet through the early repayment of TLTRO-III operations. We postponed the
discussion on the timing and methods of a gradual review of the reinvestment of
the repaid capital on maturing securities as part of the financial asset purchase
programmes, while maintaining the flexibility associated with the renewal of those
under the pandemic emergency programme (PEPP).
In fact, we will have to continue to carefully assess the effects of our decisions on
financial stability. The yield spreads between the government bonds of the
euroarea countries most exposed to market fluctuations and the German ones, which
have been increasing since the beginning of 2022, narrowed after the
announcement, in June, of the activation of flexibility in the reinvestment of the
securities purchased under the PEPP and the approval, in July, of the new
instrument against the risk of fragmentation (Transmission Protection Instrument,
TPI). The Italian spread on ten-year government bonds, which in recent weeks
had been affected by political uncertainty and increased risk aversion in the
markets, has fallen more recently to just over 210 basis points, a level still
considerably higher than those prevailing in other euro-area countries hit, like
Italy, by the sovereign debt crisis ten years ago. For its decisive and persistent
decrease to be achieved, prudence on the public budget and policies aimed at
restoring the country on a high path of growth remain crucial.
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To conclude, the costs of inflation require a decisive intervention by monetary
policy aimed at averting the danger of de-anchoring expectations and triggering a
spiral between prices and wages that would amplify the negative effects on our
economies due to geopolitical uncertainty and the energy crisis, and increase their
duration. The ECB's official rates have therefore been increased by 2 percentage
points since July, starting from the extraordinarily low levels they had reached
while dealing first with the consequences of the global financial crisis and the
sovereign debt crisis, then with those of the pandemic.
The rapid deterioration of the euro-area economic outlook that we are observing,
which is affected above all by the exceptional rise in energy costs, requires us to
continue this action. Its pace, as well as the "terminal level" that it will need to
reach will have to be discussed meeting-by-meeting, based on the flow of new
data and on the revised outlook for growth and inflation. Specifically, we need to
strike the right balance between the risk of prolonging unacceptably high inflation
and the risk to the medium-term outlook for inflation posed by the rapidly
deteriorating economic situation, as we must also be aware that, in the event of a
more serious worsening of economic conditions, financial stability risks would
further endanger price stability.
Starting from the very low values which had been necessary first during the global
financial crisis and the euro-area debt crisis and then during the pandemics,
interest rates have not yet reached a level consistent with the achievement of our
2-per-cent inflation target over the medium term. The need to continue our action
is therefore clear, but the reasons for a more gradual, though progressive,
approach are gaining ground, notwithstanding the current high level of observed
inflation. Designed by the Printing and Publishing Division of the Bank of Italy.