Amid remarkable progress on inflation and fiscal reform, Italy heads into 1998 with bright prospects for economic growth and its first-round entry into a single-currency Europe all but certain. Continued wrangling over welfare reform is a potential stumbling block in the new year, but Italy appears to be on its way to a lasting recovery.

The growth speedup began in the second quarter of 1997, but the pace has been exaggerated by government incentives to spur auto sales. Third-quarter real gross domestic product grew 1.9% from a year ago, and given the jump in October industrial production, fourth-quarter GDP should reach 2% (chart).

Although growth is expected to ease back in the first half of 1998, as the auto-led boom wanes, several key factors will fuel continued growth. First, short-term interest rates have fallen 5 percentage points in the past two years, reflecting inflation's drop from 6% to 1.6% in November. Further cuts in official rates are expected after passage of the 1998 budget by yearend 1997, as Italy aligns its rates with those across Europe prior to monetary union. Official rates are expected to drop from 6.25% currently to 4.5% or less during the first half, supplying a big boost to domestic demand.

Also, while Italy's fiscal policy will stay tighter than that of Europe generally, the severe drag of recent years will have lifted. Moreover, trade is a plus, since Italy is one of the European economies least exposed to the Asian crisis, based on an analysis by J.P. Morgan & Co. The lira should remain stable, and the downdraft from its steep appreciation in 1995 and 1996 is fading.

Even with growth set to pick up, inflation in 1998 should remain within the Bank of Italy's 2% target, especially with joblessness expected to remain above 12%, and with wage growth set to slow. Because 1997 inflation came in less than the government's target, contractual wage adjustments for 1998 will adjust downward, reflecting the undershoot, from about 4% in 1997. Slower wage growth also will help the 1998 budget deficit to dip below 3% of GDP.

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