Italian economy is holding up well, for now

We project Italian GDP to grow by around 1% in 2023, on the back of a rather strong start yet weak second half of the year. Growth is expected to accelerate again moving into 2024, but due to the weak carryover effect, the annual figure will come in somewhat lower than this year.

The Italian economy is holding up well, despite the major erosion of purchasing power (see Figure 1) and rapidly increased cost of borrowing. After a minor contraction of 0.1% QOQ in Q4 2022, GDP growth rebounded to 0.5% QOQ in Q1 2023 – compared to 0.1% QOQ for the eurozone. As such, Italy managed to avert the recession forecast a few months ago. Clearly, the major drop in energy prices helped to contain inflation, softening the erosion of purchasing power and hence the blow to household spending. It was not enough to prevent the latter from contracting, however. No, the main drivers behind the surprises in the headline GDP seem to be the unexpectedly large contraction in imports – at least partly due to energy – and better-than-expected export performance. Surveys suggest the economy continued to perform well at the start of the current quarter. Yet activity in services and manufacturing is moving in opposite ways (see Figure 2). Helped by the drop in energy costs and receding supply chain constraints, manufacturing firms will be able to continue to work their way through backlog orders. But with new orders contracting recently, the outlook for manufacturing is rather weak in our view. Meanwhile, the outlook for the services sector is more upbeat, with new business volume improving and a strong tourism season in sight.

The Good, the Bad, and the Unknown

The strong labor market, government support, and the major drop in energy prices should support household consumption for the remainder of the year. Meanwhile, grants from the European Recovery and Resilience Facility (RRF) are expected to support investment, while strengthening tourism demand boosts exports. At the same time, however, other headwinds are starting to weigh on growth. For one, we forecast the US to enter a recession in the second half of the year, hurting world trade. Second, despite the drop in energy prices, inflation is still very high at 8.8%. Third, the negative impact of increased interest rates and tightened credit standards will likely grow in the coming quarters. Bank lending has already been on a declining path since September. Moreover, for several quarters, the European Central Bank’s bank lending survey shows a lack of demand for loans due to weak investment (see Figure 3). Meanwhile curbs – and uncertainty about curbs – in the tax credit scheme for house renovations (known as the Superbonus 110) are expected to slow construction investment after two booming years (see Figure 4). In our view, European grants can certainly alleviate some pressure, but not nullify the impact of increased costs of borrowing for the private sector. Admittedly, due to a combination of factors, the estimation of the overall impact of the increase in interest rates – let alone the timing thereof – is surrounded by quite some uncertainty. Even ECB President Christine Lagarde, in her speech last week, said they lack a quantitative estimate of the impact of recent rate hikes. Hence, like everyone around us, we risk being too pessimistic and optimistic at the same time.

Meanwhile, import growth will be weighed down by both lower investment and export growth, and wishes to lower stocks in line with lower demand for goods. Yet the sharp decrease in energy imports during the previous two quarters – and its support to GDP growth – is unlikely to be repeated.

The upshot is that growth in the current quarter can still go either way, although we believe some slowdown from the first quarter is likely. As headwinds gain weight, growth will slow further in the second half of the year. We currently forecast the Italian economy to stagnate in the second part of the year, with the risk of a renewed contraction (see Figure 5).

The Recovery and Resilience Facility Puts Italy on the Spot

Helped by grants from the EU Recovery and Resilience Facility (RRF), Italian GDP growth is expected to match the euro area average in the coming years, until the program comes to an end in 2027. This marks a clear break with the two decades pre-Covid, when Italy used to be a laggard. From 2027, however, Italy will drop to the bottom of the league again due to its rapidly ageing population – which is growing old faster than most of its peers (see Figure 6). That is, unless it manages to significantly increase productivity growth and/or labor force participation rates. The National Recovery and Resilience Plan has certainly laid the foundation, but materialization will ultimately come down to implementation.

As we had expected, the plan faces implementation delays at both the national and regional governments (links in Italian). Delays can be traced back to issues such as a lack of people and materials to execute the plans, price increases, lengthy bureaucracy, novelty of the fund, and complexity. That said, we expect an acceleration in annual RRF spending going forward as some bottlenecks ease. Overall, we project GDP to be some 3% higher by the end of 2026 compared to a scenario without the RRF, with risks tilted to the upside. Based on past experience with EU cohesion funds and the like, we took a somewhat conservative stance on the share of money that a) can be absorbed/spent in this timeframe and b) leads to additional investment rather than crowding out. Apart from spending and absorption capacity, it currently seems implausible that all reforms required to receive the funds can be implemented in such a short period of time. That said, the impact of reforms on productivity growth is very hard to project, even if we were to know exactly which reforms would be implemented – which we clearly do not.

We forecast inflation to fall over the course of the year. It will reach a low in November, before it accelerates again. We project inflation to average 6% in 2023 and 2.7% in 2024.

In line with developments in the wholesale market, regulated gas tariffs have already come down substantially over the past half year and the regulated electricity tariff will drop by 55% in the current quarter. Tariffs in the non-regulated market have also come down from their peak, although on average it will take a bit longer for the lower wholesale energy prices to filter through. Despite this clear softening in energy prices, inflation remains stubbornly high. In April, headline HICP jumped to 8.8%, after it had fallen to 8.1% in March (see Figures 7 and 8). Food inflation eased a bit, but remained in double digits at 11.6%, and core inflation moved sideways at 5.3%. Yet the recent jump was caused by the energy component, which came after months of slowing inflation. The are several drivers behind this renewed increase. One is the reinstatement of general system charges on the electricity bill – which had been eliminated since Q4 2021. Another driver was the reduction of a subsidy on the gas tariff – up to a certain consumption limit – introduced by the energy regulator ARERA in April last year. The subsidy cut led to a jump in the regulated gas bill of 22.4%. A third known driver is base effects in fuel prices: Excise duties on fuel that were cut in April last year were reinstated in January.

Going forward, we expect year-on-year energy inflation to resume its downward path and turn negative in the second half of the year due to base effects. The impact of base effects is softened, however, by the ending of several support measures end June. We assume all measures apart from the energy bonus to vulnerable households will wind up as planned. That said, a thermal bonus, to be introduced in Q4, adds to the base effects. Energy inflation will turn positive again over the course of next year, when negative base effects fizzle out. We project food and core inflation to come down from their current high rates more gradually and to remain above their multidecade averages over the coming years. We project core inflation to average 4.6% this year and 2.7% next year. We expect inflation to slow somewhat further after 2024, but to remain above the ECB’s target of 2% in the medium term.

The labor market is tight and the outlook is decent. We project the unemployment rate to hover around 8% this and next year. Employment growth will slow substantially, but major job destruction is unlikely.

In March, the unemployment rate stood at 7.8%. Although this rate is high when compared to those of northern euro area peers, it is still indicative of a rather tight labor market in Italy. It averaged 9.3% over the past two decades. Moreover, employment rates, activity rates and job vacancy rates are all at record highs (see Figures 9 and 10). The relatively strong state of the labor market and good outlook sustain both gross household income and limit the need for precautionary savings. This helps to preserve private demand. That said, little can be expected from the labor market in terms of driving consumption growth. Employment growth is usually a stronger driver of income growth than hourly wage growth. And the latter is only picking up moderately, while we project the former to slow from the high rates seen in the past two years.

The working age population is contracting and the labor market tight. This means it will become harder to actually fulfill the high rate of outstanding vacancies. On the upside, participation rates, while high in historical terms, are low when compared to peers, and the opposite is true for unemployment. Hence there is quite some untapped potential, which the government is trying to activate. Time will tell if planned active labor market policy will prove successful.

As we had expected, the government has extended most energy support measures for another quarter, i.e. until the end of Q2. It also announced additional support for the fourth quarter, if the price of natural gas is higher than EUR 45/MWh – which we project. Beyond the lengthening of energy support measures, the government has also made more money available for the health sector and cut income taxes for low-income earners and families with children.

That said, the risk scenario of a budget deficit close to 7% of GDP, as outlined in a previous publication, is unlikely to materialize. Owing to the major drop in energy prices, the costs of Q1 support measures were lower than anticipated. In fact, the extension of the energy support can be financed with the windfall from Q1. Moreover, GDP growth is expected to come in much higher than we projected half a year ago, mainly due to the drop in energy prices and better-than-expected net export developments. This reduces the deficit-to-GDP ratio via the denominator. In short, our updated growth forecast for this year is in line with the outlook presented by the government in the recent Documento di Economia e Finanza 2023 (DEF) and the government’s budget deficit target of 4.5% this year is broadly within reach (see Figure 11), although risks are tilted to the upside.[1]

[1] Note that the budget balance for ’21 and ’22 has been adjusted retrospectively due to new accounting rules for tax credits. Because of the accounting rules, tax credits – mainly related to the Superbonus 110 – have to be registered as a transfer, i.e. expenditure, at the moment they are issued rather than as lower tax revenue at the moment they are used. As a result the budget deficits of 2021 and 2022 have been upped, while they will come in lower in future years than previously anticipated, all else equal.

The parliamentary budget office (UPB) has warned that financial cover for the entire budget plan for the coming years, as recorded in the updated DEF, would be hard to find. This cannot be blamed solely on the current government, since it did not cause the energy crisis and cannot be held responsible for Italy’s large debt stock nor increased interest rates. Yet it is the responsibility of the current government to find sufficient resources and cut back on excessive spending to keep debt on an affordable and sustainable path. As we have shown in previous publications, at current yields the Italian government could face affordability issues within a few years, while the primary balance (-3.6% in 2022; forecast at -0.8% in 2023) has to improve by multiple percentage points to prevent the debt-to-GDP ratio from spiraling upward. So even though the government tries to pursue a rather prudent fiscal policy in the current environment – including the reinstalment of excise duties on fuel and cuts in schemes such as the Superbonus 110 and citizens’ income – it would likely need to do more if current yields persist. Lifting the country’s growth potential would be the preferred way to go, yet it is no easy task, to say the least. Especially given the rapidly ageing population.