The risk of an ECB policy mistake could be rising, even as populist political momentum continues to build across Europe.

We see an important inflation story taking shape in Europe: Our forecast shows a decent rise in headline CPI over coming months, which we expect will reach the European Central Bank's (ECB's) target of “close to but below 2.0%” in April 2017. However, we see core inflation barely moving until 12 months later, and even then we think it will stabilize at just above 1.0%. In other words, we see no evidence of a sustained rise in inflation in the eurozone.

This matters for the ECB because of the strength of the persistent hawks on the ECB’s board. At a time when we think the ECB should be looking at ways to extend its QE program, its hawks will be emboldened by what is likely to be quite a sharp rise in headline inflation. The German Council of Economic Advisors recently said there was no need for the ECB to continue with its current stance and that it should begin to taper its asset purchases immediately. There was an immediate response to this, organized by the Centre of Economic Policy Research, which found three quarters of the European economists contacted took the opposite view.

There is clearly a risk that markets will begin to price in a significantly different ECB as inflation moves higher. Our view is that this will unwind, and that the ECB will see through this temporary rise in headline inflation. But at a time when the Fed may be getting ready to raise rates and markets are uncertain about the BoJ’s next move, the potential for an ECB tightening underscores how policy risks may be asymmetric in the next few months.

Italy as preamble to weightier political events
We continue to think it is crucial for investors to keep a close eye on European politics. We have had two major political surprises in 2016, first with Brexit and then with President-elect Trump, and we are fast approaching several important elections in Europe in 2017. The most important of these will take place in the Netherlands, France, and Germany.

But first, all eyes in Europe will be trained on Italy’s December 2016 referendum. The economic impact of this event may not be earth shattering, but the outcome could matter a great deal to opposition groups’ success in other countries. In our view, the Italian referendum may amount to an opportunity for opponents of Rome to make life harder for the government. The conservative resistance in France and the Netherlands will seek to build on the momentum of an Italian rejection of political reform.

With Italy’s referendum on political reform fast approaching, the opinion polls suggest that the reforms will be rejected. However, the margin is not large, and there are many undecided voters. Prime Minister Renzi took advantage of the recent earthquake in central Italy to try to boost his popularity, and he claimed that cost would not be an issue in the rebuilding effort. This was clearly aimed at the EU’s budgetary rules, which Italy struggles mightily to come close to meeting even without any extraordinary expenses linked to earthquake reconstruction.

The conservative resistance in France and the Netherlands will seek to build on the momentum of an Italian rejection of political reform.

A referendum victory would allow the economic reform agenda to proceed; a referendum defeat, by contrast, would have an uncertain aftermath. Even if Renzi were to resign, the president could refuse Renzi's resignation and instruct him to form a new government; then we’d be back more or less where we are now, with an economy barely growing and a half-hearted approach to the reform agenda. It is possible, though, that the referendum ends with new elections, one way or another, at which point the world would be forced to consider an advance of the conservative Five Star Movement. At the moment, new elections do not seem very likely to us.

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Political regime change in Washington D.C. may herald a new trajectory for the global economy. Whether this proves positive or negative remains to be seen.