Risks for the world economy increase ... The performance of the global economy and world trade in 2014 has fallen far short of expectations. Economic activity is gaining strength in the United States and the United Kingdom but has weakened in Japan and in the emerging economies. The risks of a further slowdown have increased, in part as a result of geopolitical tensions and the possible aggravation of structural imbalances in some emerging economies. Cyclical misalignment has led to a growing divergence of monetary policies in the advanced countries, with the stance becoming even more expansionary in the euro area while being gradually normalized in the United States.
... and economic activity in the euro area loses momentum The recovery in the euro area has faltered; economic activity in Germany contracted in the second quarter. The waning of the stimulus from foreign demand has not yet been offset by a sufficient recovery in domestic demand. The prospects for growth this year have been revised downwards both for the euro area as a whole and for the main economies. Inflation has fallen to exceptionally low levels; even medium-term expectations have fallen below the definition of price stability. The risk of further declines is increasing.
Financial markets experience renewed volatility After an extended period of calm, in recent weeks global financial markets have become volatile again. In response to the unfavourable economic situation globally and in the euro area, exacerbated by uncertainty over the political and financial situation in Greece, there have been portfolio shifts towards safer assets, such as German government securities, whose yield fell to an all-time low. The spread between ten-year Italian and German government securities, which in September had reached its lowest level since May 2011, briefly widened again, but was still far beneath the levels reached during the sovereign debt crisis. The volatility has also been reflected in share prices, which since the end of the second quarter have declined by 9 per cent in the euro area and by 14 per cent in Italy.
Monetary policy is made even more expansionary To combat the risk of a prolonged period of excessively low inflation and to boost credit and economic activity, the Governing Council of the ECB cut the rate on main refinancing operations to an all-time low of 0.05 per cent and reduced that on the deposit facility, which has been negative since June, to -0.20 per cent. It also launched a programme for the purchase of asset-backed securities and covered bonds. In September the ECB conducted its first targeted longer-term refinancing operation. The measures adopted translated into a fall in yields and a significant depreciation of the euro, which will have beneficial effects on economic activity; a further expansionary impulse could come from banks' recourse to upcoming targeted operations. The decline in inflation expectations, however, has not yet been inverted; the Council reaffirmed its intention to take further unconventional measures if necessary.
Economic activity remains weak in Italy After basically stabilizing in the second half of 2013, Italy's economy has begun to weaken again. In the first half of the year GDP was affected by the continuing fall in investment and, to a lesser extent, the effect on exports of the weakening performance of world trade. Household consumption instead improved, recording a small increase. According to our estimates, there was a further, slight decline of GDP in the third quarter.
Uncertainty weighs on the recovery of investment ... The recovery of investment is being delayed by acute uncertainty. The improvement in firms' assessments that began last year has faltered in the latest surveys, due mainly to the outlook for demand and concern about the general state of the economy. The majority of firms polled in the Bank of Italy's autumn survey indicated that the prospects for investment expenditure remained uncertain. The construction sector is still weak, despite the slower decline in house prices.
... notwithstanding the modest rise in consumption Household consumption, in sharp decline since the outbreak of the sovereign debt crisis, grew slightly in the first half of the year, boosted by the marked improvement in confidence, which lasted until the spring. Households' assessments of the general state of the economy turned more pessimistic over the summer; however, on average from June to August there was a sharp upturn in industrial production in the consumer goods sectors, and in the third quarter new car registrations rose slightly.
The labour market has stabilized but the outlook remains uncertain There are signs of stabilization in the labour market; employment returned to growth in the spring, though only slowly, then stagnated in the summer; the unemployment rate eased slightly. However, hours worked per capita and firms' expectations still indicate an uncertain outlook.
The fall in prices poses risks to the economy Inflation turned slightly negative in August and September, as much owing to trends in food and energy products as to those in the core components, whose twelve-month rate of change, while still positive, fell to an all-time low of 0.4 per cent in response to the weakness of economic activity. There is still a substantial risk that a prolonged period of excessively low inflation, or even falling prices, could jeopardize the anchoring of expectations, with adverse repercussions on the level of real interest rates and on the debt-to-GDP ratio.
Italy records capital inflows Private capital inflows to Italy have not ceased. The Bank of Italy's net debtor position on TARGET2 improved during the year, albeit with large monthly swings. The negative balance, which in August 2012 had peaked at €289 billion, narrowed to a low of €130 billion at the end of July; it then expanded again in August and September, before improving in October. The monthly fluctuations of the negative balance are influenced by technical factors, such as maturity mismatches between the government securities held by non-residents and new Treasury issues. The liquidity provided in the first targeted longer-term refinancing operation may also have allowed Italian banks to decrease their recourse to shorter-term funding on the foreign interbank market.
The cost of credit falls but lending decreases again There are signs that credit conditions have improved but not across the board. The cost of loans has fallen in response to the lowering of official interest rates; lending to households for house purchase has stabilized, while that to firms continues to contract. Surveys suggest that the difficulties in obtaining bank credit have eased somewhat, but they remain considerable for smaller firms. The continuing cyclical decline in investment is still weighing on loan demand. The ratio of new bad debts to outstanding loans to firms has fallen steadily from the peak recorded in 2013. On 26 October the results of the comprehensive assessment of the largest euro-area banks conducted by the ECB and national supervisory authorities will be released; the exercise should bolster confidence in the solidity of the euro area's banking system and strengthen its ability to finance the economy.
The Government has presented the EFD Update and the stability bill At the end of September the Government revised its April public finance forecasts to take account of the worsening economic situation. It confirmed its commitment to keep the deficit within 3.0 per cent of GDP, but has pushed back the achievement of the medium-term objective of structural balance and the reduction of the debt. Compared with the projections on a current legislation basis, net borrowing in 2015 is increased by 0.7 percentage points of GDP, to 2.9 per cent. Given the exceptional depth and duration of the recession, the Government's decisions appear well-founded. A more gradual fiscal adjustment can help avert a recessionary spiral of demand; it is justified if the room for manoeuvre that the measures provide is exploited effectively to get the economy moving again and to raise its potential for growth in the medium to longer term. The stability bill specifies the measures for achieving the budgetary targets, envisages tax reliefs on the cost of labour and makes the tax credit for medium-to-low-paid payroll workers permanent.
The recovery of domestic demand is vital ... The stimulus from exports, which in recent years underpinned GDP growth in the euro area and in Italy, could continue to weaken. The prospects for economic activity and price stability depend, more than in the past, on the recovery of domestic demand and of private and public investment.
... and so is the contribution of economic policy Monetary policy will remain expansionary for a long time to come, using all available instruments to prevent excessively low inflation from becoming rooted in expectations and in labour income trends. By exploiting the scope for manoeuvre of national policies and incisive action at EU level, fiscal policy can play a decisive role in improving macroeconomic conditions throughout the euro area. The revival of consumption and investment also requires a recovery of confidence, which depends on a broad-based reform that leaves no room for doubt over timing or outcomes.
