Foreword

2016 was in many ways a difficult year, but it was also marked by signs of progress. Though the year began shrouded in economic uncertainty, it ended with the economy on its firmest footing since the crisis.

Yet as economic uncertainty subsided, political uncertainty increased. We faced a series of geopolitical events that will shape our policy landscape for years to come. This year’s Annual Report describes how the ECB navigated these choppy waters.

2016 opened amid fears of a renewed global slowdown, reflected in pronounced financial market volatility. There was a danger that the return of inflation to our objective would be further delayed and – with inflation already very low – deflation risks were material. Just as in 2015, the Governing Council remained determined to use all the tools within its mandate to fulfil its objective.

So in March, we introduced a series of new measures to expand our monetary stimulus, including lowering our key policy rates further, increasing the asset purchase programme from €60 billion to €80 billion a month, purchasing corporate bonds for the first time, and launching new targeted longer-term refinancing operations.

As we describe in the Report, these measures proved very effective in easing financing conditions, sustaining the recovery and – eventually – supporting a gradual adjustment of inflation rates towards levels closer to our objective.

With our policy working, in December the asset purchase programme was extended by nine months to ensure longer support to financing conditions and a sustained return of inflation towards, but below, 2%. The volume of purchases was, however, reset to its original level of €60 billion per month. This reflected the success of our actions earlier in the year: growing confidence in the euro area economy and disappearing deflation risks.

Yet alongside these benefits, monetary policy has side-effects – it always does. In 2016 those side-effects were frequently in the spotlight. In this year’s Report we address some of the questions and concerns about the unintended consequences of our actions.

One is about their distributional effects, especially in terms of inequality. We show that, over the medium term, monetary policy has positive distributional effects by reducing unemployment, which benefits poorer households the most. After all, bringing people into a job is one of the most powerful drivers of lower inequality.

Another concern is about the profitability of banks, insurers and pension funds. We discuss how financial institutions have been affected by, and responded to, the low interest rate environment. We show that the ability of banks to adapt depends on their specific business models.

The Report covers other challenges for the financial sector in 2016. We look in particular at the problem of non-performing loans, what needs to be done to tackle it, and the obstacles which remain. We also have a special feature on new technology and innovation in the sector, how it might affect the structure and functioning of the sector, and what this means for overseers and regulators.

And no review of 2016 could be complete without considering the seismic political changes of the year, not least the decision of the United Kingdom to exit the European Union. Accordingly, the Report assesses Brexit from an ECB perspective. Above all, we emphasise the importance of preserving the integrity of the Single Market and the homogeneity of its rules and their enforcement.

Political uncertainty is likely to persist into 2017. But we remain confident that the economic recovery, buoyed by our monetary policy, will continue. The ECB has a clear mandate for its actions: to maintain price stability. This guided us successfully through 2016 – and it will continue to do so in the year to come.

Frankfurt am Main, April 2017

Mario Draghi

President


The euro area economy, the ECB’s monetary policy and the European financial sector in 2016

The euro area economy

The global macroeconomic environment

In 2016 the euro area economy faced a demanding external environment. Growth in both advanced and emerging market economies was modest by historical standards and there were episodes of heightened uncertainty and short-lived peaks in financial market volatility, particularly following the UK referendum on EU membership in June and the US presidential election in November. Global inflation was subdued owing to the gradually diminishing impact of past oil price declines and still abundant global spare capacity.

Global economic growth remained modest

The world economy continued to recover gradually in 2016, although at a slightly lower rate than in the previous year as a result of the deceleration in advanced economies. Economic activity only gathered pace in the second half of the year, particularly in emerging market economies. Overall, global GDP growth remained below its pre-crisis rates (see Chart 1).

2016 was marked by some significant political events, which clouded global economic prospects. In June 2016 the outcome of the UK referendum created uncertainty about the UK’s economic outlook, yet the immediate financial and economic impact proved short-lived and modest. Later in the year, the outcome of the US election brought a shift in expectations about the future policies of the incoming US administration, which led to another bout of heightened policy uncertainty.

Chart 1

Main developments in selected economies

(annual percentage changes; quarterly data; monthly data)

-10% -5% 0% 5% 10% 15% 2010 2011 2012 2013 2014 2015 2016 United States United Kingdom China Japan euro area world excluding euro area emerging market economies a) Output growth -2 -1 0 1 2 3 4 5 6 7 8 2010 2011 2012 2013 2014 2015 2016 b) Inflation rates United States United Kingdom China Japan euro area OECD

Sources: Eurostat and national data.
Notes: GDP figures are seasonally adjusted. HICP for the euro area and for the United Kingdom; CPI for the United States, China and Japan.

Advanced economies continued to grow, albeit at a lower rate than in the year before. Still accommodative financing conditions and improving labour markets supported economic activity. Growth in emerging market economies was also moderate for the year as a whole, with prospects improving significantly in the second half. Two factors were of particular influence: the continuing gradual deceleration of the Chinese economy, and the progressive easing of the deep recessions in major commodity-exporting economies. That said, growth remained restrained because of geopolitical tensions, excessive leverage, vulnerability to capital flow reversals and, in the case of commodity exporters, slow adjustment to lower revenues.

Global trade growth was weak in 2016, with the volume of world imports expanding by only 1.7% annually, following growth of 2.1% in the previous year. There is evidence that certain structural developments that boosted trade in the past – such as falling transportation costs, trade liberalisation, expanding global value chains and financial deepening – will not support trade to the same extent over the medium term. Accordingly, world trade is not very likely to grow faster than global economic activity in the foreseeable future.

Global financing conditions remained favourable throughout the year. Central banks in major advanced economies maintained an accommodative policy stance, with the Bank of England, the Bank of Japan and the ECB continuing their expansionary monetary policies. The US Federal Reserve System resumed its monetary policy normalisation by raising the federal funds target range by 25 basis points in December 2016. Financial markets showed overall resilience, in spite of spells of heightened uncertainty triggered by political events. Towards the year-end, US long-term bond yields increased markedly. It is still unclear whether this increase reflects higher growth and inflation expectations or rather a spike in term premia on US long-term bonds. Most emerging markets benefited from an improvement in external financing conditions until the US election in November. Thereafter, however, the earlier increase in capital flows towards emerging market economies started to unwind, with government bond spreads rising and pressures on currencies intensifying in a number of countries.


Abundant spare capacity continued to weigh on global inflation

During 2016 global inflation continued to be influenced by low oil prices and still abundant global spare capacity (see Chart 2). Annual headline inflation in the OECD area rose gradually towards the end of the year and reached 1.1% for the year as a whole, compared with 0.6% in 2015. Core annual OECD inflation (excluding food and energy) increased slightly to 1.8% (see Chart 1).

Chart 2

Commodity prices

(daily data)

20 40 60 80 100 120 140 160 180 200 2010 2011 2012 2013 2014 2015 2016 food (2015=100) metals (2015=100) oil (USD/barrel)

Sources: Bloomberg and Hamburg Institute of International Economics.

Oil prices recovered from a low of USD 33 per barrel at the end of January 2016 to USD 55 per barrel at the end of December. The curtailment of investment by US oil companies and a sudden increase in the number of global oil supply disruptions during the first half of the year drove prices higher.[1] Towards the end of the year oil prices were significantly affected by OPEC’s supply strategy. Following the decision on 30 November to enforce, in the first half of 2017, a cut among OPEC members (by 1.2 million barrels per day), the price of Brent crude oil increased. The upward move was also supported by an agreement between OPEC and some non-OPEC producers on a further cut in production (by 0.6 million barrels per day) on 10 December.

In 2016 non-oil commodity prices recovered; however, quotations showed opposite dynamics in the food and metal sectors. The price of agricultural commodities increased owing to weather-related issues in the first part of the year and retreated over the summer on account of abundant wheat and grain harvests. Metal prices remained at low levels in the first part of the year, as China announced environmental policies restraining the consumption of metals. As the future demand outlook improved in connection with potential new infrastructure investment in China and the United States, metal prices then partially recovered.

Overall, slowly closing output gaps in advanced economies, the modest decline in the ample spare capacity in several emerging market economies and the waning effects of past falls in oil and other commodity prices put slight upward pressure on global inflation in the second half of 2016.


Growth continued across the major economies

In the United States, economic activity slowed in 2016. Following a modest expansion in the first half of the year, real GDP growth rebounded in the second half. Growth was mainly driven by consumer spending, employment gains and strengthened household balance sheets. The drag from an inventory adjustment and declining energy investment that suppressed growth in the first half of the year diminished towards the end of the year, contributing to stronger activity. Overall, GDP growth declined from 2.6% in 2015 to 1.6% in 2016. The underlying labour market momentum remained robust, with a further decrease in the unemployment rate to 4.7% and a pick-up in wage growth at the end of the year. Inflation remained well below the target of the Federal Open Market Committee (FOMC). Overall, annual consumer price index inflation reached 2.1% in 2016, while core consumer price index inflation (excluding food and energy) increased to 2.2%.

Monetary policy remained highly accommodative in 2016. In December, in a move that was widely anticipated by financial markets, the FOMC decided to raise the federal funds target range by 25 basis points to 0.5-0.75%. The fiscal stance was slightly expansionary in the fiscal year 2016, with the fiscal deficit increasing slightly to 3.2% of GDP as a result of increased spending related to healthcare costs and higher net interest payments.

Japan saw solid growth in 2016, helped by accommodative monetary and fiscal policies, easier financial conditions and a tightening labour market. On average, real GDP growth decelerated slightly to 1% in 2016 from 1.2% in the previous year. The unemployment rate declined to 3.1%, but wage growth remained subdued. Annual headline consumer price inflation (CPI) turned negative in 2016, reaching -0.1%, mainly reflecting declining global commodity prices and the stronger yen. The Bank of Japan’s preferred measure of core inflation – CPI excluding fresh food and energy – declined somewhat compared with the previous year and stood at 0.6% in 2016. In September the Bank of Japan introduced quantitative and qualitative monetary easing with yield curve control. It also committed itself to expanding the monetary base until the observed rate of inflation exceeded its price stability target and remained above that level in a stable manner.

In the United Kingdom, the economy remained robust despite uncertainty related to the outcome of the referendum on the country’s EU membership. In 2016 real GDP increased by 2.0% according to preliminary estimates, mainly supported by robust private consumption.[2] In financial markets, the most notable response to the referendum outcome was a sharp depreciation of the pound sterling. There was a pick-up in inflation from very low levels. Monetary policy remained accommodative during 2016. In August the Bank of England’s Monetary Policy Committee cut the main policy rate by 25 basis points to 0.25%, expanded its asset purchase programme and launched a Term Funding Scheme to support the interest rate pass-through to the economy. In November the government announced a new fiscal mandate and targeted policy measures, particularly in the areas of housing and infrastructure investment, to support the economy during the transition phase.

In China, growth stabilised in 2016, supported by strong consumption and infrastructure spending. Annual GDP growth stood at 6.7% in 2016, after 6.9% in the previous year. Manufacturing investment remained weak, but property investment picked up slightly. Import demand recovered from its low in 2015, but remained weaker than in the past. Relatively subdued foreign demand weighed on exports, which in turn negatively affected imports through processing trade. Annual consumer price inflation increased to 2%, while annual producer price inflation, which has been in negative territory since March 2012, rose to -1.4%.


The effective exchange rate of the euro remained broadly stable

In 2016 the exchange rate of the euro was broadly stable in nominal effective terms (see Chart 3). In bilateral terms, however, the euro moved against some of the other major currencies. Against the US dollar, the euro was remarkably stable during most of 2016 as yields on either side of the Atlantic remained largely unchanged, but declined towards the end of the year. A weakening of the euro against the Japanese yen was partially compensated for by an appreciation against the pound sterling.

Chart 3

Euro exchange rate

(daily data)