Update on economic and monetary developments

Summary

The ECB’s monetary policy measures have continued to secure the very supportive financing conditions that are necessary to make continuous progress towards a sustained convergence of inflation rates to levels below, but close to, 2% over the medium term. The incoming information confirms a continued strengthening of the economic expansion in the euro area, which has been broadening across sectors and regions.^[1] The risks to the growth outlook are broadly balanced. While the ongoing economic expansion provides confidence that inflation will gradually head to levels in line with the Governing Council’s inflation aim, it has yet to translate into stronger inflation dynamics.

At the global level, available indicators point to sustained global growth during the second quarter of 2017. Global headline inflation has moderated, reflecting waning support from energy prices. Global financial conditions have remained overall supportive, despite increases in long-term interest rates in advanced economies.

Since the last Governing Council meeting in June, euro area long-term interest rates have risen, also on account of the improved growth prospects. Overall, the EONIA forward curve has moved upwards by around 15 basis points on average across maturities since early June. Euro area equity prices have declined for non-financial corporations but have increased for financial firms, while solid earnings expectations have continued to support prices in both sectors. Corporate bond yields have risen, as have risk-free interest rates, but corporate spreads have tightened, which is likely to reflect market expectations of solid economic growth in the euro area, among other things. The euro has appreciated in nominal effective terms.

Incoming data, notably survey results, continue to point to solid, broad-based growth in the euro area in the near term. The pass-through of the monetary policy measures is supporting domestic demand and has facilitated the deleveraging process. The recovery in investment continues to benefit from very favourable financing conditions and improvements in corporate profitability. Private consumption is supported by employment gains, which are also benefiting from past labour market reforms, and by increasing household wealth. Moreover, the global recovery should increasingly lend support to trade and euro area exports. However, economic growth prospects continue to be dampened by a slow pace of implementation of structural reforms, particularly in product markets, and by remaining balance sheet adjustment needs in a number of sectors, notwithstanding ongoing improvements. The risks surrounding the euro area growth outlook remain broadly balanced. On the one hand, the ongoing positive cyclical momentum could generate a stronger than expected economic upswing. On the other hand, downside risks primarily relating to global factors continue to exist.

Euro area annual HICP inflation was 1.3% in June, down from 1.4% in May, mainly due to lower energy price inflation. Looking ahead, on the basis of current futures prices for oil, headline inflation is likely to remain around current levels in the coming months. At the same time, measures of underlying inflation remain low and have yet to show convincing signs of a pick-up, as domestic cost pressures, including wage growth, are still subdued. Underlying inflation in the euro area is expected to rise only gradually over the medium term, supported by monetary policy measures, the continuing economic expansion and the corresponding gradual absorption of economic slack.

Broad money continued to expand at a robust pace, driven mainly by its most liquid components. In addition, the recovery in loans to the private sector observed since the beginning of 2014 is proceeding, supported by easing credit standards and increasing loan demand. Financing costs for euro area non-financial corporations and households remain favourable. The euro area bank lending survey for the second quarter of 2017 indicates that credit standards for loans to enterprises and loans to households for house purchase have further eased and that loan growth continues to be supported by increasing demand.

At its meeting on 20 July 2017, based on the regular economic and monetary analyses, the Governing Council decided to keep the key ECB interest rates unchanged. The Governing Council continues to expect the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases. Regarding non-standard monetary policy measures, the Governing Council confirmed that the net asset purchases, at the current monthly pace of €60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. The net purchases are made alongside reinvestments of the principal payments from maturing securities purchased under the asset purchase programme.

Looking ahead, the Governing Council confirmed that a very substantial degree of monetary accommodation is needed for euro area inflation pressures to gradually build up and support headline inflation developments in the medium term. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the asset purchase programme in terms of size and/or duration.

External environment

Survey-based indicators point to sustained global growth. In the second quarter of 2017 the global composite output Purchasing Managers’ Index (PMI) (excluding the euro area) remained at levels similar to those recorded in the previous two quarters, close to long-run averages, suggesting a continuing steady expansion in global activity (see Chart 1). Among the major advanced economies, the PMI declined in the United States, while it picked up in the United Kingdom compared with the first quarter. Among emerging market economies, the PMI improved in India and Brazil, in the latter case pointing to an expansion for the first time in three years. The PMI decreased in China to stand just above the expansion threshold.

Global financial conditions remain overall supportive. Equity markets have moderated slightly in advanced economies over the past few weeks. Long‑term interest rates have risen slightly in a number of major advanced economies amid market expectations about a gradual lessening of monetary accommodation. Among emerging market economies, long-term interest rates have also risen. However, in China, interbank rates have moderated slightly in the past few weeks, after a period since the beginning of the year in which financial conditions had tightened as authorities sought to curb leverage in the financial system, particularly in small banks and non-bank institutions.

Global trade growth moderated in April. Following a boost at the turn of the year, global trade growth slowed in April (see Chart 2). The volume of merchandise imports decelerated strongly, in three-month-on-three-month terms, from 1.9% in March to 0.4% in April. The slowdown in merchandise trade was mainly driven by emerging market economies. Leading indicators continue, however, to signal positive prospects in the near term. In particular, the global PMI for new export orders increased to 52.6 in June. Moreover, industrial activity developments have recently remained relatively robust across regions, which should be supportive of trade.

Global inflation slowed in May. After a slight increase in April to 2.4%, annual consumer price inflation in the Organisation for Economic Co-operation and Development (OECD) area declined to 2.1% in May. This was largely due to a declining positive contribution of energy prices which more than offset the increasing contribution of food prices. Excluding food and energy, OECD annual inflation declined slightly to 1.8% in May.

Oil prices have fluctuated in recent weeks. After declining in the course of June, Brent crude oil prices have recovered more recently. The initial decrease appears to have reflected beliefs in the market that the decision by OPEC and non-OPEC producers to extend their global supply restraint until next spring would be insufficient to rebalance the oil market and sustain higher prices. More recently, oil prices have rebounded following news of a slowdown in the growth rate in the US rig count, as well as a reduction in OECD industry stocks by 6 million barrels in May.

Economic activity in the United States rebounded in the second quarter. Real GDP growth has improved in the second quarter compared with the previous quarter, with real consumer spending and inventories recovering from the very low outcomes in the first quarter. Moreover, the tightening labour market, solid increases in asset prices and the consumers’ confidence indexes support economic growth. Headline and core inflation softened in the last three months, mostly owing to temporary factors. Annual CPI inflation declined further in June to 1.6% while inflation excluding food and energy was stable at 1.7%. In recent months, core CPI has been dampened by a sharp drop in prices for mobile telephone services and a weaker shelter component. The Federal Reserve System increased interest rates at its June meeting. It also announced the intention to start normalising its balance sheet later this year. Specifically, the principal payments received from its security holdings will be reinvested only to the extent that they exceed gradually rising caps.

The expansion of economic activity in Japan continues. Real GDP increased by 0.3% quarter on quarter in the first quarter of 2017, revised down slightly from the previous estimate. Looking ahead, solid domestic demand should support activity, while exports are set to decelerate. Industrial production increased only moderately in the first two months of the second quarter, which could be linked to weaker export performance. The labour market remains tight. The unemployment rate stood at 3.1% in May 2017, and in the same month the job-offers-to-applicant ratio reached a level unseen since the early 1990s. However, wage growth has remained weak. Consumer price inflation has also been subdued. Annual headline consumer price inflation was 0.4% in May, while consumer price inflation excluding food and energy fell to −0.2%.

In the United Kingdom, economic activity has slowed down markedly. In the first quarter of 2017, real GDP increased by 0.2% quarter on quarter, down from 0.7% in the previous quarter. The slowdown was led by a decline in private consumption, as households started to feel the squeeze from rising inflation and falling real wages. Recent indicators overall suggest that the pace of economic expansion remained relatively muted in the second quarter of 2017. Although annual CPI inflation fell to 2.7% in June, inflation rates remain elevated because of upward pressure from the depreciation of the pound sterling since the UK referendum on membership of the European Union. On 19 June 2017, almost exactly one year after the referendum, the European Union and the United Kingdom started the “Brexit” negotiations in accordance with Article 50 of the Treaties.

Momentum in the Chinese economy remains robust. GDP expanded by 6.9% in year-on-year terms in the second quarter. Consumer price inflation remains moderate. At the same time, leverage in the economy continues to rise, notwithstanding measures undertaken by the authorities to address financial market risks.

Financial developments

Euro area government bond yields have generally risen since early June, however over the period under review – 8 June to 19 July 2017 – the increase in yields took place from the last week in June. This resulted from a revision by market participants of their expectations on future monetary policy, effectively confirming that the macroeconomic outlook was firming. Overall, the euro area ten‑year overnight index swap yield and euro area ten-year sovereign bond yields, as measured by their GDP-weighted average, increased by around 15 points (see Chart 3). Across countries, the increases in sovereign bond yields ranged from a few basis points to slightly over 20 basis points. Spreads vis-à-vis the rate on German ten-year bonds overall tended to tighten, especially in Greece, Italy, Spain and Portugal. In the United Kingdom sovereign bond yields rose roughly in line with those in the euro area countries, while increases were more limited in the United States and negligible in Japan. On account of the re‑pricing that took place in the euro area government bond market at around the end of June, bond price volatility increased temporarily but reverted in the course of July to below the levels prevailing in around early June. US bond price volatility overall also declined over the review period.

Yields on bonds issued by non-financial corporations (NFCs) rose during the period under review but more modestly than risk-free rates. As a result, their spreads over AAA-rated sovereign yields tightened. Overall, the decline in the corporate spreads in spite of rising yields may have occurred, among other factors, on account of the positive momentum recorded by the euro area business cycle, a development that has historically been associated with low levels of corporate defaults. On 19 July, investment grade NFC bond spreads (on average across the rating classes AAA, AA, A and BBB) were 9 basis points lower than in early June and around 35 basis points lower than in March 2016, when the Governing Council announced the launch of the corporate sector purchase programme (CSPP). Spreads on non-investment grade corporate debt and for debt issued by financial firms (which is ineligible for purchase under the CSPP) also declined during the period under review, by around 30 and 15 basis points, respectively. On 19 July such spreads were around 270 and 35 basis points lower than in March 2016. Corporate bond yield levels also rose in other main economic areas on the back of the rise in risk-free yields.

The EONIA was stable at around −36 basis points during the review period. Excess liquidity in the banking system was little changed at around €1,650 billion, with the elevated level continuing to be supported by securities purchases under the ECB’s asset purchase programme.

The EONIA forward curve shifted upwards by around 15 basis points on average across maturities over the review period. The upward movement of the curve took place entirely from late June. Overall, the increase in the EONIA forward rates peaked for maturities ranging between four and six years, at slightly below 25 basis points. Forward rates rose marginally for very long maturities and especially for maturities shorter than two years. The curve remains below zero for horizons prior to December 2019.

Broad indices of euro area equity prices have declined since early June. At the end of the period under review the equity prices of euro area NFCs were around 1.6% lower than in early June, while prices rose by 1.7% for financial corporations. On the one hand, expectations of solid growth in earnings continued to support euro area equity prices, in line with the broad-based improvement in the euro area macroeconomic environment (see Box 2). On the other hand, the recent increase in yields, and the associated higher discount rates applied to expected profits, exerted a downward pressure on stock prices. As for financial corporations, market participants may have interpreted the upward revision to interest rate expectations as a development supportive of higher interest rate margins and future profitability, thereby explaining the diverging behaviour of equity prices between financial and non-financial corporations. Over the review period, equity prices of NFCs declined in the United Kingdom, by 1.1%, while they rose in the United States and in Japan, by slightly above 1% and by 2% respectively. The equity prices of financial corporations rose in these advanced economies by comparatively more than in the euro area, with the exception of Japan where prices remained broadly stable. Since early June market expectations of equity price volatility in both the euro area and the United States have overall remained unchanged. As at 19 July such expectations stood on an annualised basis at around 11% and 7%, respectively, values that are comparatively low in historical perspective.

In foreign exchange markets, the euro broadly appreciated in effective terms. From 8 June, the euro appreciated vis-à-vis all major currencies, including the US dollar (by 2.7%), the pound sterling (by 2.0%), the Japanese yen (by 4.2%) and the Swiss franc (by 1.3%). The broad-based appreciation reflected the evolution of market expectations regarding the monetary policy stance of major economies and the continued recovery of the euro area economy. At the same time, the currencies of some central and eastern European non-euro area Member States appreciated slightly vis-à-vis the euro, including the Czech koruna (by 0.9%) and the Hungarian forint (by 0.5%) (see Chart 4).

Economic activity

The broad-based and resilient domestic demand-driven economic expansion in the euro area continues. Real GDP continued to increase in the first quarter of 2017 (see Chart 5), on the back of positive contributions from domestic demand and, to a lesser extent, changes in inventories. The latest economic indicators, both hard data and survey results, remain buoyant and point to ongoing robust growth in the second quarter of 2017, at around the same rates as in the previous two quarters.

Household spending continues to rise and remains an important driver of the ongoing economic expansion. However, the outcome for the first quarter of 2017 was relatively low, at least in comparison with consumption developments over the previous three years, and may reflect a number of temporary factors including higher oil prices. At the same time, the annual rate of increase in real household disposable income rose to 1.7% in the first quarter, up from 1.3% in the previous quarter. This rise mainly reflects a larger contribution from property income, which suggests that stronger corporate profitability may be starting to add to household income (e.g. as a result of higher dividends), further underpinning consumption growth. In the first quarter of 2017 the saving rate remained stable on an annual basis compared with the previous quarter, as annual growth in disposable income and consumption both rose at the same rate.

Euro area labour markets continue to improve, thereby boosting household income and spending. The most recent data show that quarter-on-quarter employment rose further, by 0.4%, in the first quarter of 2017, resulting in an annual increase of 1.5%. As a result, employment currently stands 4% above the last trough in the second quarter of 2013 and is now slightly above its pre-crisis peak in the first quarter of 2008. The unemployment rate in the euro area edged down to 9.3% in April 2017 and remained at that level in May, which is 2.8 percentage points below its post-crisis peak in April 2013 (see Chart 6). This decline has been broad-based across age and gender groups. Long-term unemployment (capturing those who have been unemployed for at least 12 months) also continues to decline, but remains well above its pre-crisis level. Survey information points to continued improvements in labour markets in the period ahead.

Consumption growth is expected to remain resilient. Recent data on retail trade and new passenger car registrations are in line with sustained growth in consumer spending in the second quarter of 2017, possibly at a somewhat faster pace than that observed in the first quarter. Further employment growth, as suggested by the latest survey indicators, should also continue to support aggregate income and thus consumer spending. In addition, consumer confidence improved markedly in the second quarter and has now, for the first time, surpassed its pre-crisis peak in May 2007. Finally, households’ net worth relative to disposable income continues to rise, owing largely to valuation gains on financial assets and real estate holdings. These developments suggest further support for underlying consumption dynamics.

Euro area business investment should continue to grow in the second quarter of 2017. In the second quarter improving conditions in the capital goods sector, such as increasing capacity utilisation, rising orders, stronger confidence and survey evidence suggesting fewer perceived limits to production, taken together, signal an acceleration in the current investment momentum. Data on industrial production of capital goods up to May also suggest rising business investment in the second quarter. With regard to construction investment, monthly construction production data point to growth in the second quarter of 2017. Furthermore, survey indicators on the demand situation and the assessment of order books in the sector, as well as building permits, are still in line with positive underlying dynamics in the sh