Why Inflation Bears Watching

Italy's financial markets have been in a good mood lately. A calmer political climate has buoyed the lira and boosted the odds for a tough 1996 budget. The markets are also heartened by recent inflation news. Consumer inflation dipped to 5.6% in July, from June's 5.8%.

Longer term, though, inflation bears watching because of the lira's vulnerability and upcoming wage negotiations. Also, producer price inflation, at 9% in May, is still rising. After hitting a 25-year low of 3.6% last year, consumer inflation will end 1995 at about 51/2%, and it is headed for 6% or more in 1996.

Much of the inflation potential stems from the weak lira, which has lifted import prices and fueled the export-led recovery, thus boosting industrial output and capital spending. Soft consumer demand has offset some of these pressures: Inflation is double the 2.8% pace of hourly wages, so real pay is falling.

Recently, the lira hit a five-month high vs. the German mark, partly reflecting hopes that Prime Minister Lamberto Dini, in office since February, will stay on the job. Dini would like to reestablish the lira within Europe's exchange rate mechanism.

Because chances for early elections this year have subsided, further deficit reduction, following the recent pension reforms, seems likely. Still, parliamentary support for Dini is not strong, and political uncertainties will resurface when Parliament returns from summer recess in September.

Wages are another worry. Following the 1992 labor pact, pay settlements are linked to the government's inflation projections, now set at just 2.5% for 1995 and 3.5% for 1996. Wages will grow faster, however, because the pact also allows compensation for the difference between actual and projected inflation. Workers in paper and publishing, for example, recently agreed to a 5% wage hike beginning in July, and that's still below likely 1996 inflation.

Amid stubbornly high unemployment, wages aren't about to surge. But further monetary and fiscal restraint are crucial for both the lira and future inflation.

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