Economic and monetary developments

Overview

At its monetary policy meeting on 13 September, the Governing Council concluded that the incoming information, including the September 2018 ECB staff projections, broadly confirms the Governing Council’s previous assessment of an ongoing broad-based expansion of the euro area economy and gradually rising inflation. The underlying strength of the economy continues to support the Governing Council’s confidence that the sustained convergence of inflation to its aim will proceed and will be maintained even after a gradual winding-down of the net asset purchases. At the same time, uncertainties relating to rising protectionism, vulnerabilities in emerging markets and financial market volatility have gained more prominence recently. Therefore, 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 its aim in a sustained manner.

Economic and monetary assessment at the time of the Governing Council meeting of 13 September 2018

While the global economy maintained a steady pace in the first half of 2018, momentum is expected to moderate. Advanced economies continue to benefit from accommodative monetary policies and the US fiscal stimulus, while activity among commodity exporters has also been bolstered by the recovery in commodity prices over the past year. However, financial conditions have tightened, particularly for some emerging markets. Moreover, global trade growth has slowed and uncertainties about future trading relations have risen. Over the medium term, global economic activity is expected to expand at a pace close to potential growth, with output gaps already closed or closing in most advanced economies. Global inflationary pressures are expected to rise slowly as spare capacity diminishes.

In financial markets, euro area long-term risk-free rates have been broadly unchanged since the Governing Council’s meeting in June 2018. Sovereign bond spreads have been volatile against a background of sustained political uncertainty in Italy. Although corporate earnings remain robust, equity and bond prices of euro area financial corporations have declined amid geopolitical uncertainty and rising volatility in some emerging markets. In foreign exchange markets, the euro has broadly strengthened in trade-weighted terms.

The latest economic indicators and survey results confirm ongoing broad-based growth of the euro area economy, despite some moderation following the strong growth performance in 2017. Euro area real GDP increased by 0.4%, quarter on quarter, in the second quarter of 2018, the same rate as in the previous quarter. The ECB’s monetary policy measures continue to underpin domestic demand. Private consumption is supported by ongoing employment gains, which, in turn, partly reflect past labour market reforms, and by rising wages. Business investment is fostered by the favourable financing conditions, rising corporate profitability and solid demand. Housing investment remains robust. In addition, the expansion in global activity is expected to continue, supporting euro area exports.

The September 2018 ECB staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.0% in 2018, 1.8% in 2019 and 1.7% in 2020. Compared with the June 2018 Eurosystem staff macroeconomic projections, the outlook for real GDP growth has been revised down slightly for 2018 and 2019, mainly due to a weaker contribution from foreign demand. Although risks relating to rising protectionism, vulnerabilities in emerging markets and financial market volatility have gained more prominence recently, the risks surrounding the euro area growth outlook can still be assessed as broadly balanced overall.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 2.0% in August 2018, down from 2.1% in July. Looking ahead, on the basis of current futures prices for oil, annual rates of headline inflation are likely to hover around current levels 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 and broadening amid high levels of capacity utilisation and tightening labour markets, which is pushing up wage growth. 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 and rising wage growth.

This assessment is also broadly reflected in the September 2018 ECB staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.7% in 2018, 2019 and 2020. The outlook for HICP inflation is unchanged compared with the June 2018 Eurosystem staff macroeconomic projections. HICP inflation excluding energy and food is projected to rise gradually from 1.1% in 2018 to 1.5% in 2019 and 1.8% in 2020.

The aggregate fiscal stance for the euro area is projected to be broadly neutral in 2018, mildly expansionary in 2019, and broadly neutral again in 2020. Overall, the euro area budget deficit is expected to decline further over the projection horizon, mainly as a result of favourable cyclical conditions and declining interest payments. Although the euro area government debt-to-GDP ratio will continue to decline, it will remain elevated.

Broad money (M3) growth moderated in the context of reduced monthly net asset purchases under the asset purchase programme (APP). M3 grew by 4.0% in July 2018, after 4.5% in June. Apart from some volatility in monthly flows, M3 growth is increasingly supported by bank credit creation. The narrow monetary aggregate M1 remained the main contributor to broad money growth. The recovery in the growth of loans to the private sector observed since the beginning of 2014 is proceeding. The annual growth rate of loans to non-financial corporations (NFCs) stood at 4.1% in July 2018, while the annual growth rate of loans to households stood at 3.0%, both unchanged from June. The pass-through of the monetary policy measures put in place since June 2014 continues to significantly support borrowing conditions for firms and households, access to financing – in particular for small and medium-sized enterprises – and credit flows across the euro area. The flow of total external financing to euro area NFCs increased considerably in the second quarter of 2018.

Monetary policy decisions

Based on the regular economic and monetary analyses, the Governing Council made the following decisions. First, the Governing Council decided to keep the key ECB interest rates unchanged and continues to expect 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 the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term. Second, 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. After September 2018, the monthly pace of the net asset purchases will be reduced to €15 billion until the end of December 2018. The Governing Council anticipates that, subject to incoming data confirming its medium-term inflation outlook, net purchases will then end. Third, the Governing Council intends to reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of the net asset purchases, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

External environment

While the global economy maintained a steady pace in the first half of 2018, momentum is expected to moderate amid mounting risks and uncertainties related to rising protectionism, vulnerabilities in emerging markets and financial market volatility. Advanced economies continue to benefit from accommodative monetary policies and the US fiscal stimulus, while activity among commodity exporters has also been bolstered by the recovery in commodity prices over the past year. However, financial conditions have tightened, particularly for some emerging markets. Moreover, global trade growth has slowed and uncertainties about future trading relations have risen. Over the medium term, global economic activity is expected to expand at a pace close to potential growth. Output gaps are already closed or closing in most advanced economies, policy support will gradually diminish and China is transitioning to a lower growth path. Global inflationary pressures are expected to rise slowly as spare capacity diminishes. Risks to global activity are skewed to the downside.

Global economic activity and trade

Despite mounting risks and uncertainties, the global economy continued to expand at a steady pace in the first half of 2018. Having moderated in the first quarter, activity growth rebounded strongly in the second quarter in the United States and Japan. GDP growth also recovered modestly in the United Kingdom. Across emerging market economies (EMEs), activity was supported by continued rapid expansion in India and China. Momentum revived in Russia in the first half of this year, buoyed by the rise in oil prices, but weakened in Brazil, where disruptions associated with strikes and political uncertainty hit confidence.

Surveys suggest global activity momentum might moderate somewhat. Global manufacturing has moderated in the past few months and the global composite output Purchasing Managers’ Index (PMI) excluding the euro area declined somewhat below its long-term average in August (Chart 1). However, consumer confidence indicators remain particularly upbeat, despite the recent declines.

Further tariff increases and uncertainties about future trading relations are likely to weigh on global economic momentum going forward. In the past three months, the United States has enacted further tariff increases. The exemptions that had initially shielded the EU, Canada and Mexico from the tariff increases on steel and aluminium imports expired in June. Affected countries have announced retaliation measures. In addition, tariffs related to Section 301 of the 1974 US Trade Act – directed at concerns about technology transfers to China – took effect in July and August, affecting in total USD 50 billion of Chinese exports to the United States, and China retaliated with tariff increases on a similar value of US exports. Although the tariffs implemented so far affect a relatively small proportion of global trade, tensions over trade are high, which has heightened uncertainty about the outlook. Strains in US‑Chinese trade relations remain, with the US Administration preparing a list of an additional USD 200 billion in imports from China to be targeted in a second round of tariffs, the announcement of which was imminent at the time of the September Governing Council meeting.^[1] The United States has also initiated an investigation into auto sector trade to determine its national security implications.

A mix of concerns over trade, the gradual normalisation of monetary policies in advanced economies, and policy uncertainties in some EMEs have led to heightened tensions in financial markets in recent months. The gradual normalisation of monetary policy in the United States has continued: following the interest rate hike in June 2018, the federal funds futures curve suggests that markets anticipate further rate hikes in the coming months. The combination of rising interest rates and the stronger dollar contributed to some tightening of financial conditions across EMEs in the early summer months. Severe tensions have been observed in some EMEs, particularly Argentina and Turkey, reflecting doubts about the credibility of policy as well as high external financing requirements. While acute volatility has been limited to these countries, some spillovers to other vulnerable EMEs have been observed, with sovereign spreads rising and currencies coming under pressure.

In the near term, global economic momentum is expected to moderate. Advanced economies continue to benefit from accommodative monetary policies. A sizeable fiscal stimulus in the United States will also provide an impetus to global growth. Moreover, higher oil prices have helped stabilise investment in many oil exporting economies. However, the slowdown in global trade and rising uncertainty about future trading relations are expected to hit confidence and investment. The tightening of financial conditions in some EMEs in recent months is also expected to weigh on global momentum.

Over the medium term, global economic activity is expected to expand at a pace close to potential growth. Output gaps have already closed in many advanced economies. Moreover, policy support will gradually diminish. China’s transition to a lower growth path that is less dependent on credit and fiscal stimulus will also weigh on global demand. On the other hand, the stabilisation of prospects in EMEs will provide some support for global activity further ahead. Over the medium term, the pace of global expansion is expected to settle at below pre-crisis rates.

Turning to developments across countries, in the United States activity is expected to remain strong this year. Tight labour market conditions, with historically low unemployment levels, stable participation and an upward trend on wage growth, should support household incomes and spending, while solid corporate profits and still favourable financial conditions should bolster investment. Fiscal stimulus from tax reforms and higher expenditure are expected to support the growth outlook this year and next, before fading in 2020.

In Japan, the economic expansion is projected to decelerate gradually. While activity should benefit from accommodative monetary policy, waning fiscal support and increasingly binding capacity constraints are expected to weigh on growth. Wages are rising moderately amid a tightening labour market, which should support household spending. However, inflation is projected to remain below the Bank of Japan’s 2% inflation target.

In the United Kingdom, the outlook is for moderate growth as domestic demand remains subdued. As inflation moderates, private consumption should be supported, despite the uncertain economic outlook. However, uncertainty associated with Brexit negotiations is expected to affect investment in the interim.

In central and eastern European countries, GDP growth is projected to remain robust in the near term. Activity is supported by strong investment linked to EU funds, solid consumer spending and improvements in the labour market. Over the medium term, activity is expected to decelerate towards potential.

Recent data suggest that activity in China is decelerating in the near term. A slowing housing market and the lagged effects of earlier financial tightening may weigh on growth, while higher tariffs imposed by the United States are expected to weigh on trade. However, monetary accommodation and some fiscal support should help to sustain activity growth in the near term. Over the medium term, it is assumed that continued progress on structural reforms would lead to an orderly slowdown and some rebalancing of the Chinese economy.

Economic activity is projected to strengthen moderately in the large commodity-exporting countries. In Russia, the outlook is supported by the rise in oil prices this year, relatively low inflation and improving business and consumer confidence. On the other hand, the recently imposed US sanctions are likely to weigh on near-term growth owing to increased political uncertainties. Over the medium term, economic activity is expected to expand moderately amid a challenging business environment, weak fixed investment and a lack of structural reforms, which is undermining Russia’s growth potential. In Brazil, the short-term outlook is affected by political uncertainties and the disruptions from strikes. However, further ahead an improved labour market and continuing monetary accommodation should support consumption, as inflationary pressures remain contained.

Turkey is expected to undergo a difficult adjustment in the coming months. Rapid economic growth over the past year has led to substantial overheating. The recent depreciation of the currency, amid capital outflows and high inflationary pressures, signals a rapid deterioration in the economic environment. Indicators already point to a softening of activity, which is expected to deepen in the near term.

After strong growth in 2017, global trade indicators point to a deceleration in the first half of this year. According to CPB data, the volume of merchandise imports fell by 0.4% in June (in three-month-on-three-month terms). The picture of softening global trade is consistent with other indicators (Chart 2).

In the near term, global trade is expected to remain subdued. Increased trade protectionism is expected to weigh on trade prospects. The tariffs implemented so far affect a relatively small proportion of global trade. However, while the direct trade effects of the tariff increases are small for most countries, they have heightened concerns about the broader outlook for trade policies and the global economy. This uncertainty about future trading relations is expected to hit confidence and investment, which will also weigh on global trade prospects. Over the medium term, global trade is projected to grow broadly in line with activity.

Overall, global growth is projected to decelerate over the projection horizon. According to the September 2018 ECB staff macroeconomic projections, world real GDP growth (excluding the euro area) is expected to increase to 3.9% in 2018, before declining to 3.7% in 2019 and 2020. This projection path reflects the expected slowdown in the near term in some emerging economies, as financial conditions have tightened. Further ahead, expansion in advanced economies is projected to slow towards potential growth. At the same time, the pace of expansion in China is expected to moderate gradually. Growth in euro area foreign demand is forecast to stand at 4.1% in 2018, before declining to 3.6% in 2019 and 2020. Compared with the June 2018 projections, global GDP growth has been revised downwards for 2018 and 2019, reflecting the weaker outlook in some EMEs. Growth in euro area foreign demand has also been revised downwards, reflecting the reduced momentum observed in trade data as well as the effects of weaker projected activity.

The balance of risks for global activity is skewed to the downside. 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 remain high, 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, particularly for EMEs, disruptions associated with China’s reform process and geopolitical uncertainties associated, in particular, with Brexit-related risks.

Global price developments

Oil prices have been volatile in recent weeks. During the early summer months, oil prices declined as supply prospects improved with the cessation of disruptions in Libya and the prospect of increased supplies from OPEC and Russia. That meant that the oil price assumption underpinning the September ECB staff macroeconomic projections was about 7.5% lower in the short term than it had been in the previous projection. Since the cut-off date for the projections, however, the price of oil has risen again, reaching USD 80 per barrel on 12 September. The latest increase reflected market reaction to lower-than-expected crude oil inventories in the United States, which suggested a faster tightening of the market than had been expected.

The past increase in oil prices has put upward pressure on global consumer price inflation. In the OECD area, consumer price index (CPI) inflation rose to 2.9% in July. Excluding food and energy, inflation increased slightly to 2.1%, extending a very moderate upward trend observed over the past year (Chart 3). At the same time, despite tightening labour markets across advanced economies, wage pressures remain relatively subdued.

Looking ahead, global inflationary pressures are expected to remain contained. In the short term, the euro area’s competitors’ export prices are expected to increase following the recent pick up in oil prices. Further ahead, however, the current oil futures curve anticipates a modest decline in oil prices, implying a declining contribution from energy prices to global inflation. On the other hand, diminishing spare capacity at the global level is projected to provide some upward support for inflation.

Financial developments

Since the Governing Council’s meeting in June 2018, euro area long-term risk-free rates have remained broadly unchanged. Sovereign bond spreads have been volatile against a background of sustained political uncertainty in Italy. Although corporate earnings remain robust, equity and bond prices of euro area financial corporations have declined amid geopolitical uncertainty and rising volatility in emerging markets. In foreign exchange markets, the euro has broadly strengthened in trade-weighted terms.

Long-term yields remain broadly unchanged in the euro area and in the United States. During the period under review (from 14 June to 12 September), the euro area ten-year risk-free overnight index swap (OIS) rate and the GDP-weighted euro area ten-year sovereign bond yield remained unchanged at 0.75% and 1.10%, respectively. In the United States the ten-year government bond yield increased by 3 basis points to 2.96%, causing its spread vis-à-vis the corresponding euro area yield to increase further and reach historically high levels.

Euro area sovereign bond spreads relative to the risk-free OIS rate have been volatile, but remain broadly unchanged compared with June. Sovereign bond market conditions remained volatile throughout the review period, with spreads of Italian sovereign bonds rising amid renewed tension in the market (see Chart 5). Government bond markets in other euro area countries have also been affected to different degrees. Overall, since 14 June the GDP-weighted average of ten-year sovereign bond yields has remained broadly unchanged, standing at 36 basis points on 12 September.

The euro overnight index (EONIA) forward curve remained broadly unchanged over the review period. Market participants revised their interest rate expectations for medium horizons, resulting in a marginal flattening of the forward curve (see Chart 6). The curve remains below zero for horizons prior to 2020, reflecting market expectations of a prolonged period of negative rates.

Broad indices of euro area equity prices corrected amid increasing geopolitical uncertainty. Over the review period, equity prices of euro area financial and non-financial corporations (NFCs) decreased by around 4% and 5%, respectively (see Chart 7). Euro area equity market volatility increased over the review period amid the ongoing fluctuations in sovereign bond markets, geopolitical uncertainty and increasing volatility in emerging markets. Overall, a robust corporate profit outlook continues to support euro area equity prices, reflecting a favourable euro area macroeconomic environment.

The EONIA moved around ‑36 basis points over the review period. Excess liquidity increased by about €87 billion to around €1,909 billion. This increase is attributable to ongoing securities purchases under the Eurosystem’s asset purchase programme and a reduction in autonomous factors.

Euro area corporate bond spreads increased over the review period. Since June, the spread on investment-grade NFC bonds relative to the risk-free rate has increased by 10 basis points to stand at 69 basis points (see Chart 8). Yields on financial sector debt have increased somewhat more, resulting in a spread widening of around 12 basis points. This increase reflects a repricing of risk rather than an increase in default probabilities. Overall, 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.

In foreign exchange markets, the euro broadly strengthened 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, appreciated by 3.3%. The euro strengthened in effective terms despite depreciating vis-à-vis the US dollar and the Swiss franc, amid increased investor appetite for safe-haven currencies and the sharp depreciation of some emerging economy currencies. In bilateral terms, the euro weakened against the US dollar (by 1.2%), partly reflecting expectations about the future monetary policy stance of the Federal Reserve and the ECB, as well as against the Swiss franc (by 2.7%), but remained unchanged against the Japanese yen. By contrast, the euro broadly appreciated vis-à-vis the currencies of most emerging economies, including the Chinese renminbi (by 5.4%) and, in particular, the Turkish lira, the Brazilian real and the Russian rouble, which are among the currencies of emerging economies with the largest trade weights underlying the effective exchange rate of the euro. At the same time, the euro also appreciated against the British pound (by 1.5%) as well as against the currencies of most other non-euro area EU Member States.

Economic activity

Despite some moderation following the strong growth performance in 2017, the latest economic indicators and survey results overall confirm ongoing broad-based growth in the euro area economy. Euro area real GDP growth is supported primarily by growth in private consumption and investment. The September 2018 ECB staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.0% in 2018, 1.8% in 2019 and 1.7% in 2020. Compared with the June 2018 Eurosystem staff macroeconomic projections, the outlook for real GDP growth has been revised down slightly for 2018 and 2019, mainly due to a somewhat weaker contribution from foreign demand.

Growth moderated in the first two quarters of 2018, but remained broad-based across euro area countries. Real GDP increased by 0.4%, quarter on quarter, in the first two quarters of this year, following average growth of 0.7% in the previous five quarters (see Chart 10). The slowdown in growth at the start of the year appears to have been related largely to weaker foreign demand while capacity constraints have gradually tightened. Domestic demand (notably fixed investment spending) continued to be the main engine of growth in the second quarter of 2018. As in the previous quarter, changes in inventories made a positive contribution to real GDP growth in the second quarter, whereas net trade made a negative contribution. On the production side, economic activity in the second quarter was mainly supported by robust growth in the services and construction sectors, while value added in industry (excluding construction) expanded somewhat less.

Employment growth remained robust in the second quarter of the year. Employment grew further, increasing by 0.4%, quarter on quarter, in the second quarter of 2018 (see Chart 11), and currently stands 2.4% above the pre-crisis peak recorded in the first quarter of 2008. The increase in employment was broadly based across countries and sectors. In cumulative terms, the increase in the number of persons employed in the euro area since the trough in employment in the second quarter of 2013 amounts to 9.2 million. Hours worked per person employed increased by 0.3% in the second quarter, following a decline in the first quarter. So far, the average hours worked during the recovery have remained broadly stable, primarily reflecting the impact of several structural factors, such as 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 third quarter of 2018. The euro area unemployment rate stood at 8.2% in July – the lowest level seen since November 2008. Survey indicators have moderated somewhat from very high levels, but still point to continued employment growth in the third quarter of 2018. While indicators of labour shortages have moderated slightly in some sectors and countries, they remain at historically very high levels.

Developments in private consumption continue to be driven by the recovery in the labour market and stronger household balance sheets. Private consumption rose by 0.2%, quarter on quarter, in the second quarter of 2018, following somewhat stronger growth in the first quarter. The latest developments in retail trade and passenger car registrations are broadly in line with steady consumption growth in the near future. 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 households’ balance sheets remains an important factor behind steady consumption growth, since households’ creditworthiness is a key determinant of their access to credit. The recent increases in oil prices are unlikely to significantly dent the growth of real disposable income and private consumption (see Box 3).

The ongoing recovery in housing markets is expected to continue to support growth, albeit at a softening pace. Housing investment increased by 0.8% in the second 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 picked up again, almost reaching a seven‑year high in June, when it increased by 0.1 percentage point compared with May and 0.3 percentage point in quarterly terms. The European Commission construction confidence indicators in the last few months point to positive, albeit softening, momentum in the third quarter of 2018. In contrast, the Purchasing Managers’ Index (PMI) indicator for construction output dropped to 50.3 in July, the weakest pace of expansion in 21 months, but increased again to 51.0 in August. The housing component decreased at a stronger pace in the last two months. However, both the PMI indicators and confidence indicators remain clearly above their long-run averages.

Business investment is expected to continue to grow, supported by favourable earnings expectations, accommodative financing conditions and firms’ need to expand their productive capacity. Business investment is expected to grow solidly, in line with elevated firm valuations. Earnings expectations for listed companies in the euro area continue to support investment, while favourable financing conditions are reflected in the expansion of loans to non-financial corporations. Investment is also rising in sectors facing capacity constraints. Indeed, manufacturers of machinery and equipment, for instance in the transport sector, are expanding their productive capacity to meet rising demand.

Euro area exports recovered slightly, expanding by 0.6% in the second quarter of 2018, after the decline in the first quarter. The recovery was driven by goods exports and, to a lesser extent, by services (0.7% and 0.3%, respectively, quarter on quarter), resulting primarily from a resumption of intra-euro area exports. Extra-euro area exports remained subdued, with those to Asia rebounding only slightly and those to North America declining, which offset the strong developments seen in previous quarters. Looking ahead, survey indicators for global and euro area new manufacturing orders tend to anticipate a further moderation in export growth in the third quarter.

Overall, the latest economic indicators and survey results confirm ongoing broad-based growth in the euro area economy. Industrial production (excluding construction) declined in July, albeit with mixed signals across sectors and the larger euro area countries. As regards survey information, the European Commission’s Economic Sentiment Indicator (ESI) continued to decline in July and August, but remains well above its long-term average. The composite output PMI stabilised throughout the second quarter and remained broadly stable in July and August at levels suggesting continued solid growth.

The ongoing solid and broad-based economic growth is expected to continue. The ECB’s monetary policy measures continue to underpin domestic demand. Private consumption is supported by ongoing employment gains, which, in turn, partly reflect past labour market reforms, and by rising wages. Business investment is fostered by favourable financing conditions, rising corporate profitability and solid demand. Housing investment remains robust. In addition, the expansion in global activity is expected to continue, supporting euro area exports.

The September 2018 ECB staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.0% in 2018, 1.8% in 2019 and 1.7% in 2020 (see Chart 12). Compared with the June 2018 Eurosystem staff macroeconomic projections, the outlook for real GDP growth has been revised down slightly for 2018 and 2019, mainly due to a somewhat weaker contribution from foreign demand. The risks surrounding the euro area growth outlook can still be assessed as broadly balanced. At the same time, risks relating to rising protectionism, vulnerabilities in emerging markets and financial volatility have gained more prominence recently.

Prices and costs

According to Eurostat’s flash estimate, euro area annual HICP inflation declined slightly to 2.0% in August 2018, from 2.1% in July. While measures of underlying inflation remain generally muted, they have been increasing from earlier lows. Domestic cost pressures are strengthening and broadening amid high levels of capacity utilisation and tightening labour markets, which is pushing up wage growth. 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 and rising wage growth. This assessment is also broadly reflected in the September 2018 ECB staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.7% in 2018, 2019 and 2020 – unchanged from the June 2018 Eurosystem staff macroeconomic projections.

Headline inflation decreased slightly in August. According to Eurostat’s flash estimate, euro area annual HICP inflation declined to 2.0% in August 2018, from 2.1% in July (see Chart 13). This reflected lower HICP inflation excluding energy and food (HICPX) but also lower energy inflation. Overall, however, with rates of change of around 9%, energy inflation continued to contribute substantially to headline inflation, driven by increases in oil prices over the last months as well as by base effects.

Measures of underlying inflation remained generally muted, but on a gradually improving path. HICP inflation excluding energy and food was 1.0% in August, down from 1.1% in July. Both non-energy industrial goods and services inflation contributed to the decrease in HICPX inflation in August. Based on the available information, the slight decreases are at least partially due to transitory factors such as the calendar-related volatility of travel-related services items or that of clothing items due to changes in the timing of summer sales. Looking beyond the short-term movements from one month to the next, the range of measures of underlying inflation display an upward-sloping path since the lows of 2016 (see Chart 14). Looking ahead, it is likely that past rises in energy prices will also contribute to an increase in measures of underlying inflation, given the pervasive role of energy in the production of other goods and services. These indirect effects on inflation take longer to manifest themselves than the direct effect on energy items in the HICP such as transport or heating fuels, as they have to percolate through supply chains.^[2]

Price pressures for non-energy industrial goods in the HICP continued to increase gradually. While transitory factors contributed to the decrease of non-energy industrial goods inflation at the consumer level from 0.5% in July to 0.3% in August, pressures along the pricing chain continued to increase. Producer price inflation for non-food consumer goods rose to 0.6% in July, from 0.5% in June. This is the highest outturn since late 2012 and marks a continuation of the gradual pick-up from the lows of around 0.0% in 2016. Import price inflation became increasingly less negative since May 2018 and reached 0.0% in July, thus reducing the downward pressure from this element of the overall non-energy industrial goods pricing chain. For intermediate goods, further up the supply chain, producer price inflation increased from 3.0% in June to 3.2% in July, while import price inflation increased from 3.0% to 3.4%.

Recent developments in wage growth signal a continued upward trend and support the notion of a gradual build-up in domestic cost pressures. Annual growth in compensation per employee increased to 2.3% in the second quarter of 2018, compared with 1.9% in the first quarter of 2018 and 1.8% in the fourth quarter of 2017. Compensation per employee growth now stands considerably higher than in the first half of 2016 (see Chart 15). Its recent increase is driven mainly by the rise in the annual growth of negotiated wages to 2.2% in the second quarter of 2018, up from 1.7% in the first quarter of 2018 and 1.5% in the last two quarters of 2017. Looking ahead, wage agreements and the broadening of wage growth across sectors support the expectation of a further pick-up in wage growth. Overall, recent developments in wage growth are in line with improving labour market conditions, as factors that were weighing on wage growth, including past low inflation and the impact of labour market reforms implemented in some countries during the crisis, are beginning to fade.

Both market-based and survey-based measures of longer-term inflation expectations have remained stable. The five-year forward inflation-linked swap rate five years ahead stood at 1.69% on 12 September 2018 (see Chart 16). 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 inflation 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 and hence suggests that markets currently consider the risk of deflation as very low. According to the ECB Survey of Professional Forecasters for the third quarter of 2018, longer-term inflation expectations have remained stable at 1.9%.

The September 2018 ECB staff macroeconomic projections expect stable HICP inflation and a gradual increase in underlying inflation over the projection horizon. On the basis of the information available at end-August, these projections expect HICP inflation to average 1.7% in each year of the projection horizon, unchanged from the June 2018 Eurosystem staff macroeconomic projections (see Chart 17). The stable path of the annual average inflation rates conceals a decline in the annual rate of the energy component as the impact of the past increases in oil prices fades, which is offset by gradually rising underlying inflation as supply constraints become increasingly binding. HICP inflation excluding energy and food is expected to rise from 1.1% in 2018 to 1.5% in 2019 and 1.8% in 2020.

Money and credit

In July 2018 broad money growth moderated in the context of reduced monthly net asset purchases under the asset purchase programme (APP). Lending to the private sector continued to grow without showing any signs of slowing down. Linked to this, there was a considerable increase in the annual flow of total external financing to non-financial corporations (NFCs) in the second quarter of 2018.

Broad money growth decreased in July. The annual growth rate of M3 decreased to 4.0% in July 2018, compared with 4.5% in June (see Chart 18). This development in part reflects some volatility in recent monthly flows and base effects. Moreover, the reduction in net asset purchases (from €80 billion to €60 billion in April 2017, and then to €30 billion in January 2018) implied a smaller positive impact of the APP on M3 growth.^[3] The annual growth rate of M1, which includes the most liquid components of M3, again made a significant contribution to broad money growth, but moderated to 6.9% in July (from 7.5% in June). Money growth continued to receive support from sustained economic growth and the low opportunity cost of holding the most liquid instruments in an environment of very low interest rates.

Overnight deposits remained the main contributor to M3 growth. The annual growth rate of overnight deposits decreased in July to 7.5% (from 8.2% in June). Specifically, there was a sharp drop in the growth rate for overnight deposits held by non-monetary financial institutions, which tends to be rather volatile. The annual growth rate of overnight deposits held by NFCs declined as well, while that of overnight deposits held by households remained broadly unchanged. The annual growth rate of currency in circulation remained stable and did not indicate any 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, despite a stabilisation in the spread between the interest rates on short-term time deposits and overnight deposits since late 2017. Marketable instruments (i.e. M3 minus M2) – a small component of M3 – declined further given the currently low remuneration of these instruments.

Domestic sources of money creation remained the main driver of broad money growth (see Chart 19). 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 19), in the context of the aforementioned reduction in monthly net purchases under the APP. The declining contribution to M3 growth from the Eurosystem’s asset purchases has been cushioned by a fairly steady and robust contribution from credit to the private sector since late 2017 (see the blue parts of the bars in Chart 19). This item includes both monetary financial institution (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 19). This development is related to funding substituted against the background of more attractive TLTRO (targeted longer-term refinancing operation) funds and Eurosystem covered bond purchases as part of the third covered bond purchase programme. Credit to general government from MFIs excluding the Eurosystem continued to dampen M3 growth (see the light green parts of the bars in Chart 19). Finally, MFIs’ net external assets (see the yellow parts of the bars in Chart 19) continued to weigh on annual M3 growth.

The recovery in the growth of loans to the private sector observed since the beginning of 2014 is proceeding. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) stood at 3.4% in July (compared with 3.5% in June; see Chart 18). Across sectors, the annual growth rate of loans to NFCs remained stable at 4.1% in July, having recovered significantly from the low level seen in the first quarter of 2014, while remaining heterogeneous across countries (see Chart 20). The increase in NFC lending is supported by very favourable financing conditions and robust growth in business investment. The annual growth rate of loans to households remained unchanged at 3.0% in July, in a context of pronounced cross-country heterogeneity (see Chart 21). Lending to households is supported by very favourable financing conditions, improvements in labour markets, mature housing markets and growth in both residential investment and private consumption. In addition, banks have made progress in consolidating their balance sheets, improving profitability and reducing non-performing loans, although the level of such loans has remained high in some countries.

Banks’ funding conditions remained favourable. In July euro area banks’ composite cost of debt financing remained broadly unchanged (see Chart 22). This development reflected stabilising bank bond yields and unchanged costs of deposit funding. Since the beginning of 2018 average bank funding costs in the euro area have increased. This upward movement mainly reflects developments in bank bond yields, which have become more heterogeneous across countries, against the background of increased political uncertainty. Overall, the ECB’s accommodative monetary policy stance, the net redemption of MFIs’ longer-term financial liabilities, and the strengthening of bank balance sheets continued to contribute to favourable bank funding conditions.

Bank lending rates for NFCs and households remained close to their historical lows. The composite bank lending rate for NFCs (see Chart 23) decreased to 1.64% in July, close to the historical low of 1.62% seen in May 2018. Composite bank lending rates for loans to households for house purchase (see Chart 24) remained broadly unchanged at 1.81%, 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 above-mentioned decrease in banks’ composite funding costs has supported the decline in composite lending rates. Between May 2014 and July 2018 composite lending rates on loans to NFCs and households fell by 129 basis points and 110 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. 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.

The annual flow of total external financing to euro area NFCs is estimated to have increased considerably in the second quarter of 2018. This primarily reflects a further strengthening of bank lending dynamics, supported inter alia by the continued easing of credit standards and a decline in the relative 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 (by improving borrowing conditions) and financing requirements related to the higher number of mergers and acquisitions. At the same time, NFCs’ high retained earnings have reduced the need for external financing.

In the second quarter of 2018 the net issuance of debt securities by NFCs was more subdued than in the first quarter of 2018. In terms of monthly flows, in the second quarter of 2018, net issuance remained robust in April and May, but became negative in June as redemptions surpassed gross issuance. In terms of annual flows (see Chart 25), net issuance of debt securities has stabilised around the levels reached earlier this year, while net issuance of quoted shares continued to increase. Market data suggest that issuance activity in July and August was in line with historical seasonal patterns. Net issuance of listed shares by NFCs, by contrast, increased considerably in the second quarter of 2018.

NFCs’ cost of financing has remained close to the favourable levels recorded at the beginning of the year. In July the overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, stood at 4.4%, which is broadly unchanged compared with June 2018. In August the cost of financing is estimated to have remained constant. The current cost of external financing surpasses the historical low of July 2016 by around 37 basis points only and, therefore, remains lower than the level seen in mid‑2014 when market expectations of the introduction of the public sector purchase programme began to emerge.

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 as high-cost debt continues to be replaced by new debt issued at lower interest rates. The aggregate fiscal stance for the euro area is expected to be broadly neutral in 2018 and then mildly expansionary in 2019 before returning to broadly neutral levels in 2020. 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 September 2018 ECB staff macroeconomic projections,^[4] the general government deficit ratio for the euro area is expected to fall from 1.0% of GDP in 2017^[5] to 0.5% of GDP in 2020. This improvement is expected to be temporarily interrupted in 2019, albeit due only to transitory factors. The overall improvement in the fiscal outlook is mainly driven by favourable cyclical developments and declining interest payments. This is partly offset by a lower cyclically adjusted primary balance in 2019 and 2020 (see Chart 26). The outlook for the euro area general government deficit is broadly unchanged compared with the June 2018 Eurosystem projections.

The euro area fiscal stance is projected to be broadly neutral in 2018 and then mildly expansionary in 2019 before returning to broadly neutral levels in 2020. ^[6] Cuts to direct taxes and social security contributions are expected to contribute to the slight loosening stance as a whole over the whole projection period, and particularly so in 2019.

The decline in the euro area aggregate public debt-to-GDP ratio is projected to continue. According to the September 2018 ECB staff macroeconomic projections, the aggregate general government debt-to-GDP ratio in the euro area is expected to decline from 86.6% of GDP in 2017^[7] to 80.6% of GDP in 2020. The projected reduction in government debt is supported by both the interest rate-growth rate differential and primary surpluses (see Chart 27). Deficit-debt adjustments are, however, expected to offset some of these effects. Compared with the June 2018 projections, the decline in the aggregate euro area debt-to-GDP ratio is expected to be slightly more subdued. This is mainly due to a higher interest-growth differential which is only partly offset by higher primary surpluses. The debt outlook is projected to improve in most euro area countries, although debt levels in a few countries will continue to far exceed the reference value of 60% of GDP.

Countries need to continue their fiscal efforts in full compliance with the Stability and Growth Pact. For high debt countries in particular, 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 to any future downturns or renewed financial market instability. One factor that has significantly contributed to higher debt levels relates to financial sector support measures in several countries. Box 4 in this issue of the Economic Bulletin shows that, although the impact on debt from such support seems to have peaked, it continues to play a role. Moreover, contingent liabilities attributed to the financial sector remain elevated in several countries, which underlines the need for prudent fiscal policies going forward, as well as the importance of reinforcing the institutional framework in the euro area.

Boxes

Macroeconomic implications of increasing protectionism

Prepared by Allan Gloe Dizioli and Björn van Roye

The global trading landscape has changed rapidly in recent months. Announcements of tariffs by the US Administration and retaliation by its trading partners have raised concerns about a possible “trade war” and, potentially, a broader reversal of globalisation. On 1 March the US Administration announced tariffs of 25% on imports of steel and 10% on imports of aluminium from a wide range of countries. The first wave of tariffs relating to technology transfers on Chinese imports took effect on 6 July, followed by the announcement of retaliation in kind by the Chinese authorities. In response to the Chinese retaliation, the US Administration threatened to impose additional tariffs. In parallel, the EU and Canada implemented retaliatory measures against the US tariffs on steel and aluminium. Finally, the US Administration initiated a new investigation of imports of cars, trucks and auto parts (to determine their effects on national security) which could result in additional tariffs. Recently, however, there have also been some signs of a reduction in trade tensions resulting from a meeting between US and EU officials as well as the new NAFTA arrangements between the United States and Mexico.

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Liquidity conditions and monetary policy operations in the period from 3 May to 31 July 2018

Prepared by Dimitrios Rakitzis and Mª Carmen Castillo Lozoya

This box describes the ECB’s monetary policy operations during the third and fourth reserve maintenance periods of 2018, which ran from 3 May to 19 June 2018 and from 20 June to 31 July 2018 respectively. Throughout 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.

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Oil prices, the terms of trade and private consumption

Prepared by Nikola Bokan, Maarten Dossche and Luca Rossi

Oil prices affect private consumption through direct and indirect channels. An increase in oil prices affects households’ purchasing power directly through higher prices for oil-based energy products (e.g. petrol, heating oil). In the euro area about one-third of the economy’s total oil use is in the form of final consumption, i.e. the use by consumers of such products (Chart A). The other two-thirds comes from oil being used in the production of non-energy goods. A rise in oil prices implies an increase in the production costs of these sectors. If these costs cannot be passed on to the final prices of these goods, there will be an indirect impact on households’ purchasing power, since either wages or profits received from these sectors will be lower.^[8] Moreover, for advanced economies that produce oil (e.g. Canada, Norway, the United Kingdom and the United States) the indirect effects through wages and profits from the oil-producing sector are even more important.

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The fiscal impact of financial sector support measures: where do we stand a decade on from the financial crisis?

Prepared by João Domingues Semeano and Marien Ferdinandusse

This box takes a further look at the fiscal impact of the financial sector support measures taken in the ten years since the financial crisis struck. With the euro area economy entering its fifth year of expansion, this seems like a good moment to take stock of the fiscal costs of the crisis and the extent to which the recovery has helped to recoup them. This is done by focusing on the measures’ impact on deficits and debt, and on the state guarantees granted to banks and other financial institutions.^[9] Steps have been taken since the crisis to improve the supervision of the financial sector, the orderly resolution of failing financial institutions, the sustainability of public finances and the resilience of sovereigns, for example by establishing bodies like the Single Supervisory Mechanism, the Single Resolution Mechanism and the European Fiscal Board.

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Articles

The global financial cycle: implications for the global economy and the euro area

Prepared by Maurizio Michael Habib and Fabrizio Venditti

As financial markets became progressively more integrated internationally over the past decades, economists wondered to what extent policymakers can isolate domestic financial conditions from external factors. This article reviews the terms of this debate and provides fresh evidence on the co‑movement in capital flows and stock prices across a panel of 50 advanced and emerging economies. In particular, the article focuses on the relative importance of global risk and US monetary policy for the global financial cycle and touches upon the implications for the exchange rate regime. Global risk aversion emerges as a significant driver of capital flows and stock returns and its impact is amplified by capital account openness, but not necessarily by the exchange rate regime, which matters only for asset prices, not for capital flows. The quantitative relevance of US monetary policy and the US dollar exchange rate seems to be episodic. In particular, the correlation between US interest rates and capital flows throughout the crisis is positive, rather than negative as the theory would predict, indicating the need for further empirical analysis of the role of US monetary policy as the driver of the global financial cycle. The article also finds that financial market tensions have been typically synchronised between the euro area and the United States but that financial conditions in the two areas ‎have often decoupled. Overall, this confirms that the effectiveness of the ECB’s monetary policy has not been impaired by the global financial cycle.

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Interpreting recent developments in market‑based indicators of longer‑term inflation expectations

Prepared by Benjamin Böninghausen, Gregory Kidd and Rupert de Vincent‑Humphreys

Private sector inflation expectations are a key component of a broad range of indicators that the ECB considers when determining the appropriate monetary policy stance for achieving its price stability objective. Inflation expectations can not only affect inflation itself through the wage and price‑setting processes, but also serve as a useful cross‑check on the ECB’s and the Eurosystem’s own projections.

This article focuses on market‑based measures of longer‑term inflation expectations, which are timely indicators derived from the prices of instruments that are traded in financial markets and linked to future inflation outcomes. It reviews recent developments in the information that can be extracted from different types of market‑based indicator, starting from the period leading up to the ECB’s announcement of its expanded asset purchase programme (APP).

The fall in market‑based indicators of longer‑term inflation expectations between 2014 and mid‑2016 was consistent across major jurisdictions, possibly reflecting global concerns about weak aggregate demand and associated disinflationary pressures. Their subsequent recovery has been driven by a partial dissipation of these concerns and, in particular, a significant improvement in the euro area macroeconomic environment. The lion’s share of the movement in longer‑term inflation expectations over the past few years has stemmed from the inflation risk component of these indicators, suggesting that the balance of risks to the inflation outlook has been one of the main drivers. Indeed, information extracted from the prices of inflation options implies that the risk‑neutral probability of deflation increased noticeably in late 2014 and early 2015, before declining more recently.

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Trends and developments in the use of euro cash over the past ten years

Prepared by Laure Lalouette and Henk Esselink

The value of euro banknotes in circulation grew continuously during the period from January 2008 to December 2017, with an average annual growth rate of 6.1%. At the end of 2017, the total value of euro banknotes in circulation was €1,171 billion, with an annual growth rate of 4.0%. Seasonal patterns in circulation can be observed especially during summer holidays and the Christmas period (see Chart 1). The ratio of banknotes in circulation to nominal gross domestic product (GDP) has increased from 7.9% to 10.5% over the past ten years, indicating that, while in line with the GDP growth trend (see Chart 2), the value of euro banknotes in circulation has been growing faster than the overall economy and that other factors have therefore been contributing to this increase. Some of these factors are described in more detail in the present article.

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Statistics

Statistical annex