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Economic and monetary developments

Overview

At its monetary policy meeting on 14 June 2018, the Governing Council concluded that progress towards a sustained adjustment in inflation had been substantial so far. Since the start of its asset purchase programme (APP) in January 2015, the Governing Council has made net asset purchases under the APP conditional on the extent of progress towards a sustained adjustment in the path of inflation to levels below, but close to, 2% in the medium term. On 14 June 2018, the Governing Council undertook a careful review of the progress made, also taking into account the latest Eurosystem staff macroeconomic projections, measures of price and wage pressures, and uncertainties surrounding the inflation outlook. As a result of this assessment, the Governing Council concluded that progress towards a sustained adjustment in inflation has been substantial so far. With longer-term inflation expectations well anchored, the underlying strength of the euro area economy and the continuing ample degree of monetary accommodation provide grounds to be confident that the sustained convergence of inflation towards the Governing Council’s aim will continue in the period ahead, and will be maintained even after a gradual winding-down of its net asset purchases. The monetary policy decisions of 14 June 2018 maintain the current ample degree of monetary accommodation that will ensure the continued sustained convergence of inflation towards levels that are below, but close to, 2% over the medium term. Significant monetary policy stimulus is still needed to support the further build-up of domestic price pressures and headline inflation developments over the medium term. This support will continue to be provided by the net asset purchases until the end of the year, by the sizeable stock of acquired assets and the associated reinvestments, and by the Governing Council’s enhanced forward guidance on the key ECB interest rates. In any event, the Governing Council stands ready to adjust all of its instruments as appropriate to ensure that inflation continues to move towards the Governing Council’s inflation aim in a sustained manner.

Economic and monetary assessment at the time of the Governing Council meeting of 14 June 2018

Despite a slight softening of momentum, the near-term global outlook remains essentially solid, supported by accommodative monetary policies in advanced economies and significant fiscal stimulus in the United States. Further ahead, global activity is expected to slow as output is close to potential in many advanced economies. Global trade growth is seen as remaining resilient in the near term. However, the implementation of higher trade tariffs and the possibility of wider protectionist measures represent a key risk to global growth momentum. Global inflationary pressures are expected to rise slowly as spare capacity diminishes.

Since the Governing Council’s meeting in March 2018, euro area long-term risk-free rates have decreased. Sovereign bond spreads have exhibited considerable volatility since the second half of May, against a background of political uncertainty in Italy. The fluctuations in government bond markets have spilled over into other market segments to some extent and stock market volatility has increased. Equity and bond prices of euro area financial corporations have declined, while the impact on other market segments has remained limited. At the same time, stock prices of euro area non-financial corporations have risen, reflecting a robust corporate profit outlook. In foreign exchange markets, the euro has depreciated in nominal effective terms.

The euro area economic expansion remains solid and broad-based across countries and sectors, despite recent weaker than expected data and indicators. Quarterly real GDP growth moderated to 0.4% in the first quarter of 2018, following growth of 0.7% in the previous quarters. This moderation reflects a pull-back from the very high levels of growth in 2017, compounded by an increase in uncertainty and some temporary and supply-side factors at both the domestic and the global level, as well as weaker impetus from external trade. The latest economic indicators and survey results are weaker, but remain consistent with ongoing solid and broad-based economic growth. The ECB’s monetary policy measures, which have facilitated the deleveraging process, continue to underpin domestic demand. Private consumption is supported by ongoing employment gains, which, in turn, partly reflect past labour market reforms, and by growing household wealth. Business investment is fostered by the favourable financing conditions, rising corporate profitability and solid demand. Housing investment remains robust. In addition, the broad-based expansion in global demand is expected to continue, thus providing impetus to euro area exports. The risks surrounding the euro area growth outlook remain broadly balanced. Nevertheless, uncertainties related to global factors, including the threat of increased protectionism, have become more prominent. Moreover, the risk of persistent heightened financial market volatility warrants monitoring.

The June 2018 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.1% in 2018, 1.9% in 2019 and 1.7% in 2020. Compared with the March 2018 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised down for 2018 and remains unchanged for 2019 and 2020.

According to Eurostat’s flash estimate, euro area annual HICP inflation increased to 1.9% in May 2018, from 1.2% in April. This reflected higher contributions from energy, food and services price inflation. On the basis of current futures prices for oil, annual rates of headline inflation are likely to hover around the current level for the remainder of the year. While measures of underlying inflation remain generally muted, they have been increasing from earlier lows. Domestic cost pressures are strengthening amid high levels of capacity utilisation, tightening labour markets and rising wages. Uncertainty around the inflation outlook is receding. Looking ahead, underlying inflation is expected to pick up towards the end of the year and thereafter to increase gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion, the corresponding absorption of economic slack and rising wage growth.

This assessment is also broadly reflected in the June 2018 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.7% in 2018, 2019 and 2020. Compared with the March 2018 ECB staff macroeconomic projections, the outlook for headline HICP inflation has been revised up notably for 2018 and 2019, mainly reflecting higher oil prices.

The monetary analysis showed broad money growth gradually declining in the context of reduced monthly net asset purchases, with an annual rate of growth of M3 at 3.9% in April 2018, after 3.7% in March and 4.3% in February. While the slower momentum in M3 dynamics over recent months mainly reflects the reduction in the monthly net asset purchases since the beginning of the year, M3 growth continues to be supported by the impact of the ECB’s monetary policy measures and the low opportunity cost of holding the most liquid deposits. Accordingly, the narrow monetary aggregate M1 remained the main contributor to broad money growth, although its annual growth rate has receded in recent months from the high rates previously observed. The pass-through of the monetary policy measures put in place since June 2014 continues to significantly support borrowing conditions for firms and households and credit flows across the euro area. This is also reflected in the results of the latest Survey on the Access to Finance of Enterprises in the euro area, which indicates that small and medium-sized enterprises in particular benefited from improved access to financing.

Monetary policy decisions

Based on the regular economic and monetary analyses, the Governing Council made the following decisions. First, as regards non-standard monetary policy measures, the Governing Council will continue to make net purchases under the APP at the current monthly pace of €30 billion until the end of September 2018. The Governing Council anticipates that, after September 2018, subject to incoming data confirming its medium-term inflation outlook, it will reduce the monthly pace of the net asset purchases to €15 billion until the end of December 2018 and then end net purchases. Second, the Governing Council intends to maintain its policy of reinvesting the principal payments from maturing securities purchased under the APP for an extended period of time after the end of its net asset purchases, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation. Third, the Governing Council decided to keep the key ECB interest rates unchanged and expects them to remain at their present levels at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with its current expectations of a sustained adjustment path.

External environment

While the global economic expansion has continued, recent data point to a slight softening of momentum. Global financial conditions have remained supportive but have tightened in some emerging economies. The increase in oil prices, a reflection of still resilient global demand but also concerns about future supply in view of current geopolitical tensions, has dampened prospects in oil-importing economies. Nonetheless, the near-term global outlook remains essentially solid, supported by accommodative monetary policies in advanced economies and significant fiscal stimulus in the United States. Further ahead, global activity is expected to slow, as output is close to potential in many advanced economies. Moreover, although a further recovery in some commodity-exporting economies is envisaged, China’s anticipated transition to a lower growth path should weigh on the outlook. Global inflationary pressures are expected to rise slowly as spare capacity diminishes. Global trade growth is foreseen to remain resilient in the near term. However, the implementation of higher trade tariffs and the possibility of wider protectionist measures represent a key risk to global growth momentum. Indeed, the balance of risks for global activity and trade in the short term has worsened recently, with risks remaining skewed to the downside in the medium term.

Global economic activity and trade

Following a year of strong and highly synchronised growth, global momentum slowed somewhat in the early part of 2018. Data for the first quarter suggest that global activity was slightly weaker than expected. GDP growth in the United States slowed to 0.5%, quarter on quarter, driven by a deceleration in consumer spending, which may have reflected delayed tax refunds and the residual seasonality that has affected first quarter estimates of GDP in recent years. In the United Kingdom growth in activity also moderated, while Japan registered the first quarter-on-quarter fall in GDP in two years. In both cases, adverse weather may have played a role in constraining construction and consumption. By contrast, China’s economy expanded at a robust pace, with GDP growing by 6.8% year on year.

In the near term, the global economic expansion is expected to rebound. Survey data point to sustained growth over the coming quarters. The global composite output Purchasing Managers’ Index (PMI) fell in March but rose in April and May, remaining above the long-run average (see Chart 1). Sentiment indicators also remained upbeat, with consumer confidence close to historical highs.

The implementation of higher trade tariffs, amid ongoing discussions of further protectionist measures, represents a risk to the global economic outlook. In March, President Trump signed an order to impose import tariffs of 25% on steel and 10% on aluminium. While a number of countries were initially exempt, the United States has since decided to extend the tariffs to include the European Union, Canada and Mexico. Affected countries have pledged to increase tariffs in retaliation. The measures implemented so far affect only a small proportion of global trade and are expected to have only a small global macroeconomic effect. However, the risks of further protectionist steps have risen. Following a study of China’s intellectual property practices, the United States threatened to increase tariffs on USD 50 billion of Chinese goods, to which China pledged to retaliate. In addition, the United States launched an investigation into the national security implications of automobile imports. In both cases, nothing had been implemented by the end of the review period. Nonetheless, expectations of an escalation in the dispute could affect investment decisions, with potential effects on global growth. Looking ahead, the risks to global activity from a widespread rise in protectionism could be significant.

 

Chart 1

Global composite output PMI

(diffusion index)

Sources: Haver Analytics, Markit and ECB staff calculations.
Notes: The latest observations are for May 2018. “Long-term average” refers to the period from January 1999 to May 2018.

The global outlook continues to be supported by accommodative but somewhat tighter monetary policies. The Federal Open Market Committee raised interest rates at its March and June 2018 meetings. The Federal Funds futures curve suggests markets continue to anticipate gradual monetary tightening, with at least one more rate hike during 2018 largely priced in by futures markets and a rising probability of two more rate increases this year. Market expectations also suggest a rise in UK rates in the coming months. By contrast, the Bank of Japan still maintains a very accommodative stance. Among emerging market economies, China has continued to see a tightening of domestic financial conditions to tackle risks in the financial system, with interest rates rising again in March – although money market rates have declined moderately in recent weeks. Policy interest rates have also risen in Turkey and Argentina, as the financial environment has deteriorated. However, official rates in Brazil and Russia were cut further in March amid subdued inflationary pressures.

Despite continued monetary accommodation, global financial conditions have tightened in recent weeks, particularly in emerging market economies. Global equity markets have remained fairly resilient, with the Standard & Poor’s 500 still higher than at the start of the year. However, long-term bond yields in major advanced economies have risen. In the United States, the yield on ten-year government bonds has increased by around 50 basis points since the start of the year. The combination of rising interest rates and the strengthening of the US dollar has contributed to tighter financial conditions in emerging market economies. After a sustained recovery over the past year, capital inflows to emerging market economies slowed in April, while the spreads on bonds issued by them widened. At this time, severe financial market volatility has been restricted to a few countries, such as Argentina and Turkey, which markets appear to judge as vulnerable given high rates of inflation and sizeable external financing needs. Nonetheless, financial conditions have tightened for most emerging market economies during this period.

Oil prices have risen sharply in the past two months, although they have seen a moderation more recently. Compared with the early part of this year, the increase has, in part, reflected resilient global demand. At the same time, oil supply has been largely unchanged, as output cuts stemming from the agreement between OPEC members and other oil-producing countries were offset by an increase in production in the United States. Pressure on the spot price rose further in mid‐May, when the United States decided to withdraw from the Joint Comprehensive Plan of Action imposing sanctions on Iran. Subsequently, news that OPEC, Russia and their partners are discussing the possibility of ending the production cuts has driven the price down. Past experience suggests that oil price increases driven by shifts in supply or uncertainties about future supply have tended to be associated with weaker global activity, while demand-driven price increases have, in general, not fully offset the stronger global demand.[1] With the recent oil price increase reflecting both resilient global demand and precautionary effects associated with uncertainty about future supply, the net impact of the higher oil price on the global economy is judged to be modest overall. Nonetheless, the change in oil prices is likely to have some distributional effects across countries, with the outlook for oil exporters strengthening in particular.

Looking ahead, broad-based cyclical momentum is expected to support global activity in the near term. Despite the moderation in activity early in the year, the near-term global outlook remains essentially solid, driven by sound fundamentals. Advanced economies continue to benefit from accommodative monetary policies and, although financial conditions have tightened in recent weeks, they remain supportive for the global economy. A significant fiscal stimulus in the United States, following agreements on tax reform and increased expenditure, is also projected to provide impetus to global growth. The rise in oil prices has slightly dampened prospects in oil-importing economies. By contrast, the improvement in terms of trade is expected to help stabilise investment in many oil-exporting economies as they recover from deep recessions. Moreover, many emerging market economies, particularly China and other export-oriented Asian economies, are benefiting from the tailwinds of the global trade revival.

Over the medium term, however, the positive momentum is expected to slow as cyclical forces wane. Output gaps have already closed in many advanced economies, and spare capacity is expected to contract across emerging market economies in the coming quarters. Moreover, policy support will gradually diminish. In the United States, the boost to growth from the fiscal stimulus is expected to peak in 2019; in Japan, the effects of the fiscal stimulus are expected to fade this year. China’s transition to a lower growth path that is less dependent on credit and fiscal stimulus will also weigh on the global outlook. Over the medium term, the pace of global expansion will settle to below pre-crisis rates.

Turning to developments across countries, in the United States, activity is expected to rebound this year. The upward pressure of tight labour market conditions on wage growth, together with continued improvement in investment and still favourable financial conditions are expected to support domestic demand. Moreover, the fiscal policy changes, including the tax reform and the two-year budget deal, are expected to boost the growth outlook.

In the United Kingdom, economic prospects remain relatively subdued against the background of uncertainties related to the process of the country leaving the European Union. Real GDP growth is expected to rebound modestly after the weak outturn in the first quarter of this year. Thereafter, the outlook is one of moderate growth, as an expected moderation in inflation and a pick-up in wage growth provide some support for private consumption.

In Japan, the economic expansion is projected to decelerate gradually. In the near term, activity is expected to rebound after the weak first-quarter outcome, supported by the accommodative monetary policy stance. Further ahead, growth is projected to decelerate as fiscal support wanes and spare capacity diminishes. Wages are rising moderately in the context of a tightening labour market, which is expected to support household spending and contribute towards a modest increase in inflation.

Economic activity in central and eastern European countries is foreseen to remain robust. GDP growth will be supported by strong investment linked to the absorption of EU funds. In addition, solid consumer spending is projected to be boosted by improvements in the labour market.

In China, activity is projected to decelerate moderately. Output has recently been supported by strong consumption, government support and solid export performance, which have offset the effects of a mild slowdown in housing market activity amid slowing credit growth and tightening financial conditions. Further ahead, the pace of expansion is foreseen to slow gradually, consistent with the emphasis of China’s leadership on accepting slower expansion in order to reduce risks and address imbalances in the economy.

Economic activity is gradually strengthening in the large commodity-exporting countries. In Russia, despite the moderation in the pace of growth in the second half of 2017, the outlook is supported by rising oil prices, declining inflation and improving business and consumer confidence. Over the medium term, economic activity is expected to expand moderately amid the fiscal challenges weighing on the business environment. In Brazil, labour market improvements and continuing monetary accommodation should support consumption, against the backdrop of moderate inflationary pressures. The stabilisation in commodity prices and terms of trade should also be supportive of activity over the forecast horizon. At the same time, political uncertainty and the reversal of previously benign external financial conditions are expected to weigh on demand.

Recent indicators suggest a slight softening of global trade momentum in the near term. According to CPB Netherlands Bureau for Economic Policy Analysis, having risen strongly in January and February, growth in merchandise imports fell to 1.6% in March (in three-month-on-three-month terms). Other indicators have also pointed to a moderation in global trade during the first few months of 2018 (see Chart 2).

 

Chart 2

World trade in goods

(left-hand scale: three-month-on-three-month percentage changes; right-hand scale: diffusion index)

Sources: Markit, CPB Netherlands Bureau for Economic Policy Analysis and ECB calculations.
Note: The latest observations are for May 2018 (global PMI manufacturing and global PMI new export orders) and March 2018 (trade).

Further ahead, global imports are projected to slow gradually, consistent with the projected cyclical deceleration in global activity. In the past, global trade has exhibited pronounced pro-cyclicality. Recent trade outcomes are consistent with that experience: as global activity recovered in 2015 and 2016, global trade rebounded, rising even faster than global output. Looking ahead, as the global expansion moderates, world trade growth is also foreseen to slow. Over the medium term, trade projections are anchored around the view that global imports will grow broadly in line with activity. This is in line with the evidence that the longer-term structural factors that previously drove the fast expansion of global trade, including trade liberalisation, reductions in tariffs and transportation costs and the expansion of global value chains, have waned since the financial crisis. However, risks have increased. In particular, the outlook for trade will depend on how discussions over trade tariffs progress.

Overall, global growth is projected to remain broadly stable over the projection horizon. According to the June 2018 Eurosystem staff macroeconomic projections, world real GDP growth (excluding the euro area) is expected to increase from 3.8% in 2017 to 4.0% in 2018, before declining to 3.9% and 3.7% in 2019 and 2020 respectively. This projection path reflects the expected slowdown in activity in advanced economies and the expected structural slowdown in China, partly offset by a modest gain in dynamism in emerging market economies. Growth in euro area foreign demand is forecast to expand by 5.2% in 2018, 4.3% in 2019 and 3.7% in 2020. Compared with the March 2018 projections, global GDP growth has been revised downwards for 2018 and 2019, reflecting weaker than expected growth in the short term. Growth in euro area foreign demand has been revised upwards slightly over the whole projection horizon, reflecting expectations of more trade-intensive growth in some central and eastern European economies.

The balance of risks for global activity has worsened in recent weeks, with risks judged to be balanced in the short term but skewed to the downside in the medium term. On the upside, the US fiscal package could have a stronger impact on activity than expected. However, the near-term prospects of greater trade protectionism have increased, which could have a significant impact on global activity and trade. Other downside risks relate to the possibility of a further tightening of global financial conditions, disruptions associated with China’s reform process and geopolitical uncertainties associated, in particular, with Brexit-related risks.

Global price developments

Global consumer price inflation has been broadly stable in recent months. In the OECD area, headline inflation rose to 2.3% in April. Excluding food and energy, OECD inflation fell slightly to 1.9% (see Chart 3). At the same time, despite tightening labour markets across advanced economies, wage pressures remain relatively subdued.

Looking ahead, global inflation is expected to rise in the near term. In the short term, inflation is foreseen to increase following the sharp pick-up in oil prices. Later on, however, the current oil futures curve anticipates falling oil prices over the projection horizon, pointing to a negative contribution from energy prices to inflation. However, slowly diminishing spare capacity at the global level is expected to support underlying inflation.

 

Chart 3

OECD consumer price inflation

(year-on-year percentage changes; percentage point contributions)

Source: OECD.
Note: The latest observation is for April 2018.

Financial developments

Since the Governing Council’s meeting in March 2018, euro area long-term risk-free rates have decreased. An uptick in market-based measures of long-term inflation expectations was balanced by a decrease in real rates. Sovereign bond spreads have exhibited considerable volatility since the second half of May, against a background of political uncertainty in Italy. The fluctuations in government bond markets have spilled over into other market segments to some extent and stock market volatility has increased. Equity and bond prices of euro area financial corporations have declined, while the impact on other market segments has remained limited. At the same time, stock prices of euro area non-financial corporations (NFCs) have risen, reflecting a robust corporate profit outlook. In foreign exchange markets, the euro has depreciated in nominal effective terms.

Long-term government bond yields have increased in the euro area and in the United States (see Chart 4). During the period under review (from 8 March to 13 June), the GDP-weighted euro area ten-year sovereign bond yield increased by 11 basis points to 1.20%. Likewise, the ten-year government bond yield in the United States increased by 11 basis points to 2.97%, leaving its spread vis-à-vis the corresponding euro area yield at historically high levels.

 

Chart 4

Ten-year sovereign bond yields

(percentages per annum)

Sources: Thomson Reuters and ECB calculations.
Notes: Daily data. The vertical grey line denotes the start of the review period (i.e. 8 March 2018). The latest observation is for 13 June 2018.

Euro area GDP-weighted sovereign bond spreads relative to the risk-free OIS rate have been volatile. Overall they have risen since early March. After experiencing comparatively moderate fluctuations over the first part of the review period, spreads of Italian sovereign bonds rose substantially after 15 May when markets became aware of details of a draft programme being put forward by the incoming government (see Chart 5). Since then sovereign bond market conditions have remained volatile, with Italian sovereign spreads considerably above their April levels. Government bond markets in other euro area countries have also been affected to different degrees. Overall, since 8 March the GDP-weighted average of ten-year sovereign bond yields has increased by 17 basis points to stand at 40 basis points on 13 June.

 

Chart 5

Euro area sovereign bond spreads vis-à-vis the OIS rate

(percentages per annum)

Sources: Thomson Reuters and ECB calculations.
Notes: The spread is calculated by subtracting the ten-year OIS rate from the sovereign yield. The vertical grey line denotes the start of the review period (8 March 2018). The latest observation is for 13 June 2018.

The euro overnight index average (EONIA) forward curve shifted down during the review period. The curve remains below zero for horizons prior to 2020, reflecting market expectations of a prolonged period of negative rates (see Chart 6).

The EONIA averaged -36 basis points over the review period. Excess liquidity increased slightly, rising by about €17 billion to around €1,903 billion. This increase was attributable to ongoing securities purchases under the Eurosystem’s asset purchase programme. Liquidity conditions are discussed in more detail in Box 1.

 

Chart 6

EONIA forward rates

(percentages per annum)

Sources: Thomson Reuters and ECB calculations.

Equity indices for euro area NFCs rose over the review period. By contrast, financial corporation equity indices experienced a substantial decline, mainly in the wake of recent tensions in euro area sovereign debt markets. Euro area equity market volatility increased in March and again towards the end of May, amid the ongoing fluctuations in sovereign bond markets (see Chart 7). However, market volatility remained below the levels observed in February, when a correction was triggered by market perceptions of rising inflation. Over the review period, equity prices of euro area NFCs increased by around 2%. Overall, a robust corporate profit outlook continues to support euro area equity prices, reflecting a favourable euro area macroeconomic environment. Financials were influenced by sovereign debt market tensions, resulting in a decrease of around 12% over the review period. Against this background, in the United States equity prices of NFCs rose by around 1%, while those of financial corporations declined by 5%.

 

Chart 7

Euro area and US equity price indices

(index: 1 January 2015 = 100)

Sources: Thomson Reuters and ECB calculations.
Notes: The vertical grey line denotes the start of the review period on 8 March 2018. The latest observation is for 13 June 2018.

Yield spreads on bonds issued by NFCs have been less affected by recent sovereign bond market tensions. Since late April, the spread on investment-grade NFC bonds relative to the risk-free rate has increased by 23 basis points to stand at 58 basis points (see Chart 8). Yields on financial sector debt have increased somewhat more, resulting in a widening of the spread by around 32 basis points. However, corporate bond spreads remain significantly below the levels observed in March 2016, prior to the announcement and subsequent launch of the corporate sector purchase programme.

 

Chart 8

Euro area corporate bond spreads

(basis points)

Sources: iBoxx indices and ECB calculations.
Notes: The vertical grey line denotes the start of the review period on 8 March 2018. The latest observation is for 13 June 2018.

In foreign exchange markets, the euro weakened slightly in trade-weighted terms (see Chart 9). Over the review period, the nominal effective exchange rate of the euro, measured against the currencies of 38 of the euro area’s most important trading partners, depreciated by 1.3%. This development largely reflected a weakening of the euro vis-à-vis major currencies, in particular the US dollar (-5.3%) and the Chinese renminbi (-4.3%), and partly unwound the currency’s appreciation since June 2017. The euro also depreciated against the British pound (-1.4%), the Japanese yen (-1.4%) and the Swiss franc (-1.0%). The depreciation against the currencies of the euro area’s largest trading partners was only partly offset by a pronounced strengthening of the euro against the currencies of some emerging markets, most notably the Turkish lira (15.4%), the Brazilian real (8.3%) and the Russian rouble (4.5%), as well as by a more moderate strengthening against the currencies of some non-euro area EU Member States.

 

Chart 9

Changes in the exchange rate of the euro vis-à-vis selected currencies

(percentage changes)

Source: ECB.
Notes: “EER-38” is the nominal effective exchange rate of the euro against the currencies of 38 of the euro area’s most important trading partners. All changes have been calculated using the foreign exchange rates prevailing on 13 June 2018.

Economic activity

Despite recent weaker than expected data and indicators, the euro area economic expansion remains solid and broad-based across countries and sectors after a period of growth rates well above potential growth. Euro area real GDP growth is supported primarily by growth in private consumption and investment. The latest survey results and incoming data point to more moderate but still solid growth momentum in the near term. The June 2018 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.1% in 2018, 1.9% in 2019 and 1.7% in 2020. Compared with the March 2018 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised down for 2018 and remains unchanged for 2019 and 2020.

Growth moderated in the first quarter of 2018, but remained solid and broad-based across euro area countries. Real GDP increased by 0.4%, quarter on quarter, in the first quarter of this year, following growth of 0.7% in the previous quarter (see Chart 10). The slowdown in growth at the start of the year appears to have been related to temporary factors, as well as more lasting cyclical factors (see Box 2). Domestic demand (notably private consumption and fixed investment spending) continued to be the main engine of growth in the first quarter of 2018. Changes in inventories made a positive contribution to real GDP growth in the first quarter, whereas net trade made a negative contribution. On the production side, economic activity was mainly supported by robust growth in the services and construction sectors, while value added in industry (excluding construction) contracted somewhat.

 

Chart 10

Euro area real GDP and its components

(quarter-on-quarter percentage changes and quarter-on-quarter percentage point contributions)

Source: Eurostat.
Note: The latest observations are for the first quarter of 2018.

Employment growth remained robust in the first quarter of the year. Employment growth rose further, increasing by 0.4%, quarter on quarter, in the first quarter of 2018 (see Chart 11), and stands 1.9% above the pre-crisis peak recorded in the first quarter of 2008. Employment increased in most euro area countries and the increase was broadly based across sectors. With the latest increase, cumulative employment growth in the euro area since the trough recorded in the second quarter of 2013 amounts to 8.4 million. The strong employment growth seen during the recovery was accompanied by broadly stable average hours worked, which reflects primarily the impact of several structural factors (for example, the large share of part‑time workers in total employment and other compositional effects).

Short-term indicators point to continuing strength in the labour market in the second quarter of 2018. The euro area unemployment rate continued to decline and stood at 8.5% in April – the lowest level seen since December 2008. The decline was broad-based across age and gender groups and unemployment durations. Survey indicators have moderated somewhat from very high levels, but still point to continued employment growth in the second quarter of 2018. In that context, signs of labour shortages have increased in some countries and sectors.

 

Chart 11

Euro area employment, PMI assessment of employment, and unemployment

(quarter-on-quarter percentage changes; diffusion index; percentages of the labour force)

Sources: Eurostat, Markit and ECB calculations.
Notes: The Purchasing Managers' Index (PMI) is expressed as a deviation from 50 divided by 10. The latest observations are for the first quarter of 2018 for employment, May 2018 for the PMI and April 2018 for the unemployment rate.

Developments in private consumption continue to be driven by the recovery in the labour market and stronger household balance sheets. Private consumption rose by 0.5%, quarter on quarter, in the first quarter of 2018, following somewhat weaker growth in the last quarter of 2017. Recent developments in retail trade and new passenger car registrations pose negative risks. However, from a longer-term perspective, increasing labour income is supporting the solid underlying momentum in consumer spending, which is also reflected in elevated consumer confidence. In addition, the strengthening of household balance sheets remains an important factor for steady consumption growth, since households’ creditworthiness is a key determinant of their access to credit.

The ongoing recovery in housing markets is expected to continue to drive growth. Housing investment increased by 1.2% in the first quarter of 2018, reflecting the continuing recovery in many euro area countries and in the euro area as a whole. Recent short-term indicators and survey results point to positive but decelerating momentum. Construction production in the buildings segment recorded its third consecutive decline in March, falling by 0.3%, month on month. In contrast, Purchasing Managers’ Index (PMI) indicators for construction output rose in May, extending the current period of expansion to a year and a half, with a similar pattern seen for the PMI indicator for housing output. The European Commission’s construction confidence indicator for the buildings construction segment increased in May. Both the PMI indicators and the confidence indicator remain clearly above their long-run averages.

Business investment is expected to continue to grow, supported by favourable earnings expectations, solid demand and accommodative financing conditions. According to the euro area sectoral accounts for the fourth quarter of 2017, business margins (measured as the ratio of the net operating surplus to value added) remained elevated. Furthermore, earnings expectations for listed companies in the euro area are still at high levels. Moreover, increasing capacity utilisation and rising orders in the capital goods sector, as well as strong confidence and demand, signal overall a continuation of the dynamic investment momentum. The latest information from the April 2018 European Commission industrial investment survey points to expectations of a strong increase in real manufacturing investment of 7.0% in the euro area in 2018, which is an upward revision compared with the previous survey conducted in November 2017. Investment is expected to increase in 2018 in most large euro area countries and in the euro area as a whole (see Chart 12).

 

Chart 12

Plans for real industrial investment in 2018

(volumes; annual percentage changes)

Source: European Commission industrial investment survey.

Euro area export growth weakened in the first quarter of 2018. Following a sustained expansion in the second half of 2017, euro area total real export growth decreased by 0.4% in the first quarter of 2018. The deceleration was driven mainly by goods exports, which fell by 0.6%, quarter on quarter. The decline in extra-euro area exports of goods in February and March was broad-based across a large number of destinations. Survey indicators for global and euro area new manufacturing orders confirm a more moderate trend in exports in the second quarter.

The latest economic indicators and survey results are weaker, but remain consistent with ongoing solid and broad-based economic growth. Industrial production (excluding construction) declined in April. The decline was fairly broadly based across sectors and across the larger euro area countries. The European Commission’s Economic Sentiment Indicator (ESI) and the composite output PMI both declined throughout the first quarter and continued to decline, albeit at a somewhat slower pace, in April and May. Both indicators remain above their long-term averages.

The ongoing solid and broad-based economic growth is expected to continue. The ECB’s monetary policy measures, which have facilitated the deleveraging process, continue to underpin domestic demand. Private consumption is supported by ongoing employment gains, which, in turn, partly reflect past labour market reforms, and by growing household wealth. Business investment is fostered by the favourable financing conditions, rising corporate profitability and solid demand. Housing investment remains robust. In addition, the broad-based increase in global demand is expected to continue, thus providing impetus to euro area exports. The risks surrounding the euro area growth outlook remain broadly balanced. Nevertheless, uncertainties related to global factors, including the threat of increased protectionism, have become more prominent. Moreover, the risk of persistent heightened financial market volatility warrants monitoring.

The June 2018 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.1% in 2018, 1.9% in 2019 and 1.7% in 2020 (see Chart 13). Compared with the March 2018 ECB staff macroeconomic projections, projected real GDP growth has been revised down for 2018 and remains unchanged for 2019 and 2020.

 

Chart 13

Euro area real GDP (including projections)

(quarter-on-quarter percentage changes)

Sources: Eurostat and the article entitled “Eurosystem staff macroeconomic projections for the euro area, June 2018”, published on the ECB’s website on 14 June 2018.
Notes: The ranges shown around the central projections are based on the differences between actual outcomes and previous projections carried out over a number of years. The width of the range is twice the average absolute value of these differences. The method used for calculating the ranges, involving a correction for exceptional events, is documented in “New procedure for constructing Eurosystem and ECB staff projection ranges”, ECB, December 2009, available on the ECB’s website.

Prices and costs

According to Eurostat’s flash estimate, euro area annual HICP inflation increased to 1.9% in May 2018, from 1.2% in April. On the basis of current futures prices for oil, annual rates of headline inflation are likely to hover around the current level for the remainder of the year. While measures of underlying inflation remain generally muted, they have increased from earlier lows. Domestic cost pressures are strengthening amid high levels of capacity utilisation, tightening labour markets and rising wages. Uncertainty about the inflation outlook is receding. Looking ahead, underlying inflation is expected to pick up towards the end of the year and thereafter to increase gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion, the corresponding absorption of economic slack and rising wage growth. This assessment is also broadly reflected in the June 2018 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.7% in 2018, 2019 and 2020, and HICP inflation excluding energy and food at 1.1%, 1.6% and 1.9% respectively.

Headline inflation increased considerably in May. According to Eurostat’s flash estimate, euro area annual HICP inflation increased strongly, rising from 1.2% in April to 1.9% in May 2018 – the highest rate recorded since April 2017 (see Chart 14). The increase in May reflected higher contributions from services and food price inflation and, in particular, from energy inflation. The increase in energy inflation reflected both a strong month-on-month increase in energy prices, owing to higher oil prices, and an upward base effect.

 

Chart 14

Contributions of components of euro area headline HICP inflation

(annual percentage changes; percentage point contributions)

Sources: Eurostat and ECB calculations.
Note: The latest observations are for May 2018 (flash estimates).

Measures of underlying inflation have remained generally muted but have increased from their earlier lows. After standing at 1.0% for three consecutive months HICP inflation excluding energy and food declined to 0.7% in April but then rebounded to 1.1% in May, according to the flash estimate (see Chart 15). This pattern mainly reflected volatility owing to the different timing of Easter. HICP inflation excluding energy, food, travel-related items and clothing – with the latter two components tending to be influenced by calendar effects and by the timing of sales periods – remained relatively stable in April (the latest month for which this breakdown was available). Overall, looking beyond the volatility in recent months, measures of underlying inflation have generally remained stable, but have increased from the low levels recorded in 2016.

 

Chart 15

Measures of underlying inflation

(annual percentage changes)

Sources: Eurostat and ECB calculations.
Notes: The range of underlying measures consists of the following: HICP excluding energy; HICP excluding energy and unprocessed food; HICP excluding energy and food; HICP excluding energy, food, travel-related items and clothing; the 10% trimmed mean; the 30% trimmed mean; and the weighted median of the HICP. The latest observations are for May 2018 (HICP excluding energy and food – flash estimate) and April 2018 (all other measures).

Strengthening domestic cost pressures largely offset the increasing downward pressure from the past exchange rate appreciation on non-energy goods price inflation. The impact of the past appreciation of the effective euro exchange rate has been evident in the decline in import price inflation.[2] However, extra-euro area import prices for non-food consumer goods declined only slightly further in annual terms in April 2018, falling to -2.0% (after -1.9% in March). Import price inflation for intermediate goods, which signals price pressures earlier in the domestic production chain, improved somewhat, to stand at -0.8% in April, after ‑1.5% in March. In contrast to import price inflation, producer price inflation for domestic sales of non-food consumer goods remained resilient to downward pressure from the past euro exchange rate appreciation, likely reflecting rising domestic cost pressures and pricing power in an environment of robust economic growth. Annual producer price inflation for non-food consumer goods was stable at 0.5% between February and April 2018, up from rates of around 0.2% in the second half of 2017. At the consumer level, HICP non-energy industrial goods inflation declined to 0.2% in May, from 0.3% in April. This was lower than the rates observed at the beginning at the year, but the pattern can in part be attributed to strong volatility in annual rates of inflation for the clothing and footwear sub-component, partly owing to changing seasonal sales patterns in recent years.

Recent developments in wage growth data signal a continued upward trend and support the picture of a gradual build-up in domestic cost pressures. Annual growth in compensation per employee was 1.9% in the first quarter of 2018, up from 1.8% in the fourth quarter of 2017, and now stands considerably higher than in the first half of 2016 (see Chart 16). This increase mirrors the rise in the annual growth of negotiated wages (which was 1.9% in the first quarter of 2018, up from 1.6% in the fourth quarter of 2017), and recent wage agreements in euro area countries support the expectation of a further pick-up in wage growth. Overall, recent developments in wage growth echo improving labour market conditions, as other factors that weighed on wage growth, including past low inflation and the ongoing impacts from labour market reforms implemented in some countries during the crisis, begin to fade.

 

Chart 16

Contributions of components of compensation per employee

(annual percentage changes; percentage point contributions)

Sources: Eurostat and ECB calculations.
Note: The latest observations are for the first quarter of 2018.

Both market-based and survey-based measures of longer-term inflation expectations have remained largely unchanged. The five-year forward inflation-linked swap rate five years ahead stood at 1.74% on 12 June 2018, broadly unchanged compared with the end of April (see Chart 17). The forward profile of market-based measures of inflation expectations continues to point to a prolonged period of low inflation, with only a very gradual return to levels below, but close to, 2%. The risk-neutral probability of negative average inflation over the next five years implied by inflation options markets is negligible, suggesting that markets currently consider the risk of deflation to be very low. According to the ECB Survey of Professional Forecasters for the second quarter of 2018, measures of longer-term inflation expectations remained broadly stable, standing at 1.9%. The same result was also reported in the latest Consensus Economics and Euro Zone Barometer surveys.

 

Chart 17

Market-based measures of inflation expectations

(annual percentage changes)

Sources: Thomson Reuters and ECB calculations.
Note: The latest observations are for 12 June 2018.

The June 2018 Eurosystem staff macroeconomic projections expect HICP inflation to remain flat at 1.7% in each year of the projection horizon (see Chart 18). [3] The profile of the inflation projection conceals two competing developments: a gradual increase in HICP inflation excluding energy and food, which is expected to rise from 1.1% in 2018 to 1.6% in 2019 and 1.9% in 2020, and a declining contribution from energy inflation, given the technical assumption that oil prices will evolve in line with the oil futures curve. The expected rise in underlying price pressures reflects in particular increasing labour market tightness and concomitant wage pressures, especially in some countries. In an environment of robust growth, such labour cost increases are likely to be passed through to consumer prices. Compared with the March 2018 ECB staff macroeconomic projections, HICP inflation has been revised up by 0.3 percentage point for 2018 and 2019, on account of the increase in oil prices and small upward revisions to growth in compensation per employee.

 

Chart 18

Euro area HICP inflation (including projections)

(annual percentage changes)

Sources: Eurostat and the article entitled “Eurosystem staff macroeconomic projections for the euro area, June 2018”, published on the ECB’s website on 14 June 2018.
Note: The ranges shown around the central projections are based on the differences between actual outcomes and previous projections carried out over a number of years. The width of the ranges is twice the average absolute value of these differences. The method used for calculating the ranges, involving a correction for exceptional events, is documented in “New procedure for constructing Eurosystem and ECB staff projection ranges”, ECB, December 2009, available on the ECB’s website.

Money and credit

Since the fourth quarter of 2017, broad money growth has been gradually declining in the context of reduced monthly net asset purchases under the asset purchase programme. At the same time, loan growth to the private sector remained on a path of moderate expansion, significantly supported by the pass-through of the monetary policy measures put in place since June 2014. The annual flow of total external financing to non-financial corporations (NFCs) is estimated to have moderated somewhat in the first quarter of 2018.

M3 growth has been gradually declining since the fourth quarter of 2017 in the context of reduced monthly net asset purchases. The annual growth rate of M3 stood at 3.9% in April 2018, compared with 3.7% in March and 4.3% in February (see Chart 19). In March and April, developments in broad money were also driven by base effects, leading to some volatility in the annual growth rates. The reduction in net asset purchases (from €80 billion to €60 billion in April 2017, and then to €30 billion in January 2018) has led to a smaller positive impact on M3 growth, as both the increase in seller deposits (provided the seller belongs to the money-holding sector) and portfolio rebalancing effects have tended to become less pronounced.[4] At the same time, money growth remained supported by the impact of the ECB’s monetary policy measures, solid economic growth and the low opportunity cost of holding the most liquid instruments in an environment of very low interest rates. Although the annual growth rate of M1, including the most liquid components of M3, moderated further to 7.0% in April (from 7.5% in March), it continued to contribute significantly to broad money growth.

 

Chart 19

M3, M1 and loans to the private sector

(annual percentage changes; adjusted for seasonal and calendar effects)

Source: ECB.
Notes: Loans are adjusted for loan sales, securitisation and notional cash pooling. The latest observation is for April 2018.

Overnight deposits continued to be the main contributor to M3 growth. Specifically, the annual growth rate of overnight deposits held by households and NFCs remained robust in April (both at 8.4%). By contrast, the more volatile annual growth rate of overnight deposits held by non-monetary financial institutions continued to moderate. The annual growth rate of currency in circulation remained contained, thereby indicating no tendency on the part of the money-holding sector to substitute deposits with cash in an environment of very low or negative interest rates. Short-term deposits other than overnight deposits (i.e. M2 minus M1) continued to have a negative impact on M3. The annual rate of change of marketable instruments (i.e. M3 minus M2) – a small component of M3 – was again negative in April. This development was mainly driven by the negative contribution of money market fund shares/units, reflecting the current low attractiveness of these instruments in terms of remuneration.

Domestic sources of money creation remained the main driver of broad money growth (see Chart 20). From a counterpart perspective, the positive contribution to M3 growth from general government securities held by the Eurosystem decreased further (see the red parts of the bars in Chart 20), in the context of a decline in monthly net purchases under the asset purchase programme. This decrease was broadly offset by an increase in the contribution of credit to the private sector (see the blue parts of the bars in Chart 20), which includes both MFI loans to the private sector and MFI holdings of debt securities issued by the euro area private non-MFI sector. As such, it also covers the provision of credit through the Eurosystem’s purchases of non-MFI debt securities under the corporate sector purchase programme. The persistent contraction in MFIs’ longer-term financial liabilities (excluding capital and reserves) held by non-MFI euro area residents contributed positively to M3 growth (included alongside other counterparts in the dark green parts of the bars in Chart 20). This development is related to funding substituted against the background of more attractive TLTRO funds and Eurosystem covered bond purchases as part of the third covered bond purchase programme. Government bond sales from euro area MFIs excluding the Eurosystem contributed to the negative annual growth of credit to general government from MFIs excluding the Eurosystem and thus dampened M3 growth (see the light green parts of the bars in Chart 20). Finally, the annual flow of MFIs’ net external assets was broadly zero, reflecting fewer sales of government bonds by non-euro area residents (see the yellow parts of the bars in Chart 20).

 

Chart 20

M3 and its counterparts

(annual percentage changes; contributions in percentage points; adjusted for seasonal and calendar effects)

Source: ECB.
Notes: Credit to the private sector includes MFI loans to the private sector and MFI holdings of debt securities issued by the euro area private non-MFI sector. It thus includes the Eurosystem’s holdings of debt securities in the context of the corporate sector purchase programme. The latest observation is for April 2018.

The annual growth rate of loans to the private sector remained on a path of moderate expansion. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) stood at 3.1% in April (compared with 3.0% in March; see Chart 19). Across sectors, the annual growth rate of loans to NFCs remained stable at 3.3% in April, having recovered significantly from the low level seen in the first quarter of 2014 (see Chart 21). The increase in NFC lending, although moderate, is supported by very favourable financing conditions and robust growth in business investment. The annual growth rate of loans to households remained unchanged at 2.9% in April (see Chart 22). This is fostered by very favourable financing conditions, improvements in labour markets, strengthened housing markets and growth in both residential investment and private consumption. At the same time, overall loan growth remained heterogeneous across countries. In addition, banks have made progress in consolidating their balance sheets, improving profitability and reducing non-performing loans, although the level of such loans remains high in some countries and may continue to affect banks’ intermediation capacity.[5]

 

Chart 21

MFI loans to NFCs in selected euro area countries

(annual percentage changes)

Source: ECB.
Notes: Adjusted for loan sales, securitisation and notional cash pooling. The cross-country dispersion is calculated on the basis of minimum and maximum values using a fixed sample of 12 euro area countries. The latest observation is for April 2018.

 

Chart 22

MFI loans to households in selected euro area countries

(annual percentage changes)

Source: ECB.
Notes: Adjusted for loan sales and securitisation. The cross-country dispersion is calculated on the basis of minimum and maximum values using a fixed sample of 12 euro area countries. The latest observation is for April 2018.

Banks’ funding conditions remained close to the historically low levels seen in December 2017. Euro area banks’ composite cost of debt financing remained broadly unchanged in April, following an increase in the first quarter of 2018 (see Chart 23). This development was due to an increase in bank bond yields while banks’ cost of deposit funding remained broadly stable. The ECB’s accommodative monetary policy stance, the net redemption of MFIs’ longer-term financial liabilities, and the strengthening of bank balance sheets have all contributed to favourable bank funding conditions. At the same time, bank bond yields became more heterogeneous across countries in May 2018, against the background of political uncertainty in Italy (see Section 2).

 

Chart 23

Banks’ composite cost of debt financing

(composite cost of deposit and unsecured market-based debt financing; percentages per annum)

Sources: ECB, Markit Iboxx and ECB calculations.
Notes: The composite cost of deposits is calculated as an average of new business rates on overnight deposits, deposits with an agreed maturity and deposits redeemable at notice, weighted by their corresponding outstanding amounts. The latest observation is for April 2018.

Bank lending rates for NFCs and households remained close to their historical lows. The composite bank lending rate for NFCs (see Chart 24) stood at 1.70% in April, close to the historical low of 1.67% seen in January 2018. Composite bank lending rates for loans to households for house purchase (see Chart 25) remained broadly unchanged at 1.83%, only slightly above the historical low of 1.78% observed in December 2016. Overall, composite bank lending rates for loans to NFCs and households have decreased by significantly more than market reference rates since the ECB’s credit easing measures were announced in June 2014. This signals an improvement in the pass-through of monetary policy measures to bank lending rates. The decrease in banks’ composite funding costs, mentioned above, has supported the decline in composite lending rates. Between May 2014 and April 2018, composite lending rates on loans to NFCs and loans to households for house purchase fell by 123 basis points and 108 basis points respectively. The reduction in bank lending rates on NFC loans was particularly strong in the euro area countries that were most affected by the financial crisis, leading to a more homogeneous transmission of monetary policy to such rates across countries. Over the same period, the spread between interest rates charged on very small loans (loans of up to €0.25 million) and those charged on large loans (loans of above €1 million) in the euro area narrowed considerably. This indicates that small and medium-sized enterprises have generally benefited to a greater extent from the decline in bank lending rates than large companies.

 

Chart 24

Composite lending rates for NFCs

(percentages per annum; three-month moving averages)

Source: ECB.
Notes: The indicator for the total cost of bank borrowing is calculated by aggregating short and long-term rates using a 24-month moving average of new business volumes. The cross-country standard deviation is calculated using a fixed sample of 12 euro area countries. The latest observation is for April 2018.

 

Chart 25

Composite lending rates to households for house purchase

(percentages per annum; three-month moving averages)

Source: ECB.
Notes: The indicator for the total cost of bank borrowing is calculated by aggregating short and long-term rates using a 24-month moving average of new business volumes. The cross-country standard deviation is calculated using a fixed sample of 12 euro area countries. The latest observation is for April 2018.

The annual flow of total external financing to euro area NFCs is estimated to have moderated somewhat in the first quarter of 2018. This reflects a decline in the issuance of debt securities and listed shares over the course of 2017. By contrast, bank lending dynamics have improved, supported, inter alia, by the continued easing of credit standards and a decline in the cost of bank lending. Overall, the recovery in NFCs’ external financing, observed since early 2014, has been supported by the strengthening of economic activity, the pass-through of the monetary policy measures put in place (thus improving borrowing conditions) and financing requirements related to the larger numbers of mergers and acquisitions. At the same time, NFCs’ high retained earnings have reduced the need for external financing.

Net issuance of debt securities by NFCs increased significantly in the first quarter of 2018. Net issuance was robust in January, but moderated in February and March, nonetheless still recording the highest volume since the third quarter of 2016. Market data for April and May suggest that issuance activity remained strong, but at lower levels than those recorded in the first quarter. Net issuance of listed shares by NFCs also increased significantly in the first quarter of 2018.

NFCs’ cost of financing has returned to the favourable levels recorded at the beginning of the year. In April, the overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, stood at 4.5%, down by around 14 basis points from March. In May, the cost of financing is estimated to have remained constant. While the current cost of external financing is around 43 basis points above the historic low of July 2016, it remains lower than the level seen in mid-2014 when market expectations of the introduction of the public sector purchase programme began to emerge.

According to the latest Survey on the Access to Finance of Enterprises , SMEs in the euro area continued to signal further improvements in the availability of external sources of finance. They attributed these improvements mainly to banks being more willing to extend credit. SMEs indicated that all of the macroeconomic and firm-related factors examined in the survey had had a positive impact on the availability of external finance, reporting no major changes from the last survey. They again ranked access to finance as their lowest concern, although significant cross-country differences still exist. The percentage of distressed SMEs in the euro area has remained at the low level of around 4% since 2015 – significantly below the levels in the region of 15% seen in and around 2012. This is due in part to the accommodative standard and non-standard monetary policy measures in place. On balance, a somewhat smaller share of SMEs reported an increase in turnover and a smaller net percentage indicated a rise in profits in the context of growing labour costs and other costs (for material, energy and interest expenses).

Fiscal developments

The euro area budget deficit is projected to decline further over the projection horizon (2018‑20), mainly as a result of favourable cyclical conditions and declining interest payments. The aggregate fiscal stance for the euro area is expected to be mildly expansionary in 2018 and broadly neutral in 2019‑20. Although the euro area government debt-to-GDP ratio will continue to decline, it will remain elevated. In particular the countries with high debt levels would benefit from additional consolidation efforts to set their public debt ratio firmly on a downward path.

The euro area general government budget deficit is projected to decline further over the projection horizon (2018‑20). Based on the June 2018 Eurosystem staff macroeconomic projections,[6] the general government deficit ratio for the euro area is expected to fall from 0.9% of GDP in 2017 to 0.5% of GDP in 2020. The improvement in the fiscal outlook is still mainly driven by favourable cyclical developments and declining interest payments, while the cyclically adjusted primary balance is projected to deteriorate somewhat in 2019 (see Chart 26). The outlook for the euro area general government deficit is slightly more favourable compared with the March 2018 projections.

 

Chart 26

Budget balance and its components

(percentage of GDP)

Sources: ECB and June 2018 Eurosystem staff macroeconomic projections.
Notes: The data refer to the aggregate general government sector of the euro area.

The euro area fiscal stance is projected to be mildly expansionary in 2018 and broadly neutral in 2019‑20. [7] The expansionary fiscal stance in 2018 is due to some minor tax cuts and to growth in government spending being more dynamic than trend nominal GDP. Expansionary policies are in place in the majority of euro area countries. In 2019‑20 partly sizeable cuts in taxes and social security contributions are projected to be largely offset by more subdued growth in structural primary spending, namely due to lower social payments and compensation of employees. By contrast, government investment is expected to rebound, slightly exceeding trend nominal GDP over the course of the projection horizon.

The decline in the euro area aggregate public debt-to-GDP ratio is projected to continue. According to the June 2018 Eurosystem staff macroeconomic projections, the aggregate general government debt-to-GDP ratio in the euro area is expected to decline from 86.7% of GDP in 2017 to 80.4% of GDP by the end of 2020. The projected reduction in government debt is supported mainly by favourable developments in the interest rate-growth rate differential and primary surpluses (see Chart 27). Deficit-debt adjustments are, however, expected to contribute somewhat to debt accumulation. Compared with the March 2018 projections, the decline in the aggregate euro area debt-to-GDP ratio is expected to be slightly more subdued, mainly due to less favourable interest rate-growth rate differentials. The debt outlook is projected to improve in most euro area countries; in a few countries, however, debt levels will continue to far exceed the reference value of 60% of GDP. In the medium to long run, ageing-related costs are projected to pose a challenge to fiscal sustainability, with additional upside risks to be expected should previous reforms in the areas of pensions, health care and long-term care be reversed. For an assessment of the 2018 Ageing Report projections see Box 4 entitled “The 2018 Ageing Report – population ageing poses tough fiscal challenges” in this issue of the Economic Bulletin.

 

Chart 27

Drivers of change in public debt

(percentage points of GDP)

Sources: ECB and June 2018 Eurosystem staff macroeconomic projections.
Notes: The data refer to the aggregate general government sector of the euro area.

Countries need to continue their fiscal efforts in full compliance with the Stability and Growth Pact. In particular for high debt countries, further consolidation efforts are essential to set the public debt ratio firmly on a downward path, as their high debt levels render them particularly vulnerable in the event of any future downturns or renewed financial market instability. On 23 May the European Commission released its country-specific recommendations for economic and fiscal policies for EU Member States, with the exception of Greece. For an assessment, see Box 5 entitled “Country-specific recommendations for fiscal policies under the 2018 European Semester” in this issue of the Economic Bulletin.

Boxes

Liquidity conditions and monetary policy operations in the period from 31 January to 2 May 2018

Prepared by Riccardo Costantini

This box describes the ECB’s monetary policy operations during the first and second reserve maintenance periods of 2018, which ran from 31 January to 13 March 2018 and from 14 March to 2 May 2018 respectively. During this period the interest rates on the main refinancing operations (MROs), the marginal lending facility and the deposit facility remained unchanged at 0.00%, 0.25% and ‑0.40% respectively.

More

The recent slowdown in euro area output growth reflects both cyclical and temporary factors

Prepared by Gonzalo Camba-Mendez and Magnus Forsells

Following very strong growth rates in 2017, quarterly real GDP growth in the euro area moderated to 0.4% in the first quarter of 2018. The slowdown in growth at the start of the year, which appears to reflect temporary factors as well as more lasting cyclical factors, was in line with developments in economic indicators, notably survey data (see Chart A). Both the composite output Purchasing Managers’ Index (PMI) and the European Commission’s Economic Sentiment Indicator (ESI) declined throughout the first quarter of 2018. However, it is important to note that, like output growth, these indicators fell back from exceptionally high levels.

More

Monitoring the exchange rate pass-through to inflation

Prepared by Elke Hahn and Derry O’Brien

Exchange rate developments can play an important role in shaping the outlook for HICP inflation. As a change in the exchange rate can affect consumer prices with considerable delays and as the impact can depend on the economic situation at the time, assessing the exchange rate pass-through requires constant monitoring. Between April 2017 and May 2018, the exchange rate of the euro appreciated by about 8% in nominal effective terms and by about 10% against the US dollar. This box briefly recalls how exchange rate changes are transmitted to consumer prices in the euro area. The box also looks at indicators at different stages of the pricing chain to gauge the degree of the pass-through at the current juncture. The focus is on the monitoring of the pass-through to exchange rate-sensitive components of the HICP excluding energy and food.

More

The 2018 Ageing Report: population ageing poses tough fiscal challenges

Prepared by Carolin Nerlich

This box presents the main projection results of the 2018 Ageing Report for euro area countries. The 2018 Ageing Report, published on 25 May 2018, is the latest of the reports prepared every three years by the Ageing Working Group of the Economic Policy Committee.[8] The report provides long-term projections of total public age-related costs and their components, which comprise pensions, health care, long-term care, education expenditure and unemployment benefits, for all EU countries over the period 2016‑70. These projections are, of course, dependent on the underlying assumptions.[9]

More

Country-specific recommendations for fiscal policies under the 2018 European Semester

Prepared by Stephan Haroutunian, Sebastian Hauptmeier and Nadine Leiner-Killinger

On 23 May the European Commission issued its 2018 European Semester Spring Package of policy recommendations for Member States. The package includes country-specific recommendations (CSRs) for economic and fiscal policies for all EU Member States.[10] It also covers recommendations regarding the implementation of the European Union’s Stability and Growth Pact (SGP) for a number of countries.[11] With regard to fiscal policies, the recommendations focus in particular on Member States’ compliance with the SGP on the basis of the Commission’s 2018 spring forecast and the Commission’s assessment of countries’ policy plans as reflected in the updates of the stability and convergence programmes released in April. This year’s European Semester exercise is important particularly with a view to avoiding any repetition of mistakes made prior to the financial crisis when sufficient fiscal buffers were not built up in economic good times and the ensuing recession was aggravated by the sudden necessity of pro-cyclical fiscal tightening. Against this background, this box examines the fiscal policy recommendations that are addressed to 18 euro area countries (i.e. excluding Greece).

More

Articles

Foreign direct investment and its drivers: a global and EU perspective

Prepared by Federico Carril-Caccia and Elena Pavlova

The relevance of foreign direct investment (FDI) as a source of economic activity has increased rapidly over the last decade. Between 2000 and 2016 the share of FDI stock in global GDP increased from 22% to 35%. Following a decline during the Great Recession, mergers and acquisitions (M&As), the most dynamic component of FDI, have recovered, reaching a record value of USD 1.2 trillion in the first quarter of 2018. The intensification of FDI activity has important implications for both origin and destination countries in terms of, for example, economic growth, productivity, wages and employment. Moreover, the expansion of multinational enterprises (MNEs) has been accompanied by the creation of complex cross-border production chains, which also has important implications.

This article presents several findings regarding the main developments in and determinants of FDI over the past decade, at both global and EU level. Since the beginning of the 2000s there has been a gradual shift in the global FDI landscape, with emerging market economies (EMEs) gaining in prominence both as a source of and as a destination for such investment. EMEs have attracted a growing share of FDI flows, reaching more than 50% of the world’s total inward FDI in 2013. In addition, FDI flows are dominated by a relatively small number of M&As. In 2016 M&As with a value in excess of USD 1 billion accounted for only 1% of all FDI projects, but they generated 55% of total FDI flows. Moreover, evidence suggests that FDI and exports are not competing but complementary strategies for serving foreign markets. Finally, since 2008 EU countries are no longer the world’s main FDI investors and recipients. Nevertheless, econometric analysis shows that belonging to the EU dramatically boosts FDI flows in member countries.

More

Measuring and interpreting the cost of equity in the euro area

Prepared by André Geis, Daniel Kapp and Kristian Loft Kristiansen

Equity capital is among the main sources of funding for euro area non-financial corporations (NFCs), making it an important factor in the transmission of monetary policy. From a central bank perspective, improving the measurement and understanding of the cost of equity is therefore essential.

Unlike the cost of debt, which has declined substantially in recent years, the cost of equity has remained relatively stable at elevated levels. Results from the analysis performed in this article suggest that a persistently high “equity risk premium” (ERP) has been the key factor underpinning the high cost of equity for euro area NFCs. In fact, since the start of the global financial crisis, increases in the ERP have largely offset the fall in the yield of risk-free assets.

This article argues that the widely used workhorse model to derive the cost of equity and the ERP, namely the three‑stage dividend discount model, can be improved upon. In particular, incorporating short-term earnings expectations, discounting payouts to investors with a discount factor with appropriate maturity, and considering share buy-backs all yield beneficial refinements. This in turn would strengthen the theory and basis of the model and improve the robustness of its estimates. Most notably, share buy-back activity seems to matter, specifically for the level of the ERP. Notwithstanding such improvements in the modelling approach, estimating the ERP, particularly its level, remains subject to considerable uncertainty. Ultimately, such uncertainty advocates the use of a variety of models and survey estimates, as well as a focus on the dynamics, rather than on the level, of the ERP.

From an applied perspective, the article demonstrates that cost of equity modelling can be used to disentangle the different drivers of changes in equity prices. This is helpful from a monetary policy perspective, as changes in equity prices can contain important information about the economic outlook and warrant monitoring for financial stability purposes. Moreover, the article shows that adding an international perspective to the analysis of the ERP for the overall market may provide valuable insights for policymakers. For instance, the greater reliance on share buy-backs among companies in the United States than those in the euro area appears to be behind some of the recent steeper decline in the ERP in the United States when compared with the ERP in the euro area.

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Measures of underlying inflation for the euro area

Prepared by Michael Ehrmann, Gianluigi Ferrucci, Michele Lenza and Derry O’Brien

Headline inflation can be noisy, blurring the signal on the medium-term inflationary pressure relevant for monetary policy. To help distinguish signal from noise in the data, central banks monitor measures of underlying inflation. As there are many ways of measuring underlying inflation, it is important to understand the properties of the various indicators and what factors may account for any divergence between them. This article describes in detail the measures of underlying inflation typically used at the ECB and evaluates them against a set of empirical criteria.

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http://www.ecb.europa.eu/pub/pdf/ecbu/ecb.eb_annex201804.en.pdf

© European Central Bank, 2018

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All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

This Bulletin was produced under the responsibility of the Executive Board of the ECB. Translations are prepared and published by the national central banks.

The cut-off date for the statistics included in this issue was 13 June 2018.

ISSN 2363-3417 (html)

ISSN 2363-3417 (pdf)

DOI 10.2866/124744 (html)

EU catalogue No QB-BP-18-004-EN-Q (html)

EU catalogue No QB-BP-18-004-EN-N (pdf)

  1. See the box entitled “Global implications of low oil prices”, Economic Bulletin, Issue 4, ECB, 2016.
  2. For further details, see the box entitled “Monitoring the exchange rate pass-through to inflation” in this issue of the Economic Bulletin.
  3. See the article entitled “Eurosystem staff macroeconomic projections for the euro area, June 2018”, published on the ECB’s website on 14 June 2018.
  4. See, for example, the article entitled “The transmission of the ECB’s recent non-standard monetary policy measures”, Economic Bulletin, Issue 7, ECB, 2015.
  5. See also Section 3 of Financial Stability Review, ECB, May 2018.
  6. See the “June 2018 Eurosystem staff macroeconomic projections for the euro area”, ECB, 2018. The fiscal projections are based on the no-policy assumption. Thus, the projections only include measures that have already been adopted or are close to being adopted by the respective parliaments.
  7. The fiscal stance reflects the direction and size of the stimulus from fiscal policies on the economy, beyond the automatic reaction of public finances to the business cycle. It is measured as the change in the structural primary balance, i.e. the cyclically adjusted primary balance ratio net of government support to the financial sector.
  8. See “The 2018 Ageing Report: Economic & Budgetary Projections for the 28 EU Member States (2016‑2070)”, European Commission, May 2018.
  9. The Ageing Report projections are based on a set of demographic and macroeconomic assumptions and a commonly agreed methodology. These were published in a separate report entitled “2018 Ageing Report: Underlying Assumptions & Projection Methodologies”, European Commission, November 2017. As discussed later, for a number of countries, these underlying assumptions are rather favourable.
  10. Except for Greece, where the monitoring of fiscal performance will continue within the framework of the European Stability Mechanism (ESM) programme throughout its duration (i.e. until August 2018). Greece was therefore exempt from the obligation to submit a medium-term budgetary plan (Stability Programme) and a National Reform Programme in April, and did not receive recommendations.
  11. The CSRs were finalised and approved by the Member States’ economics and finance ministers on 22 June. They are scheduled to be endorsed by the European Council on 28-29 June. The adoption of the CSRs by the Economic and Financial Affairs Council (ECOFIN Council) at the meeting scheduled for 13 July will formally conclude the 2018 European Semester.