Update on economic and monetary developments

Summary

Incoming information since the last Governing Council meeting in early September confirms the previous assessment of a protracted weakness in euro area growth dynamics, the persistence of prominent downside risks and muted inflation pressures. The risks surrounding the euro area growth outlook remain on the downside. In particular, these risks pertain to the prolonged presence of uncertainties, related to geopolitical factors, rising protectionism and vulnerabilities in emerging markets. At the same time, ongoing employment growth and increasing wages continue to underpin the resilience of the euro area economy. Against this overall background, the Governing Council at its October meeting kept its monetary policy stance unchanged, confirming the decisions taken at the previous meeting in September. The comprehensive package of policy measures that was decided at the September meeting provides substantial monetary stimulus, and thus will contribute to a further easing in borrowing conditions for firms and households. This will support the euro area expansion, the ongoing build-up of domestic price pressures and, thus, the sustained convergence of inflation to the Governing Council’s medium-term inflation aim.

Survey indicators suggest subdued, but stabilising, global economic activity in the third quarter of 2019. Following a protracted period of weakness, the global manufacturing Purchasing Managers’ Index (PMI) has improved over recent months and returned to expansionary territory. The global services PMI remained expansionary in the third quarter. Global trade (excluding the euro area) contracted in the first half of 2019 owing to weak intra-Asian trade, but short-term indicators of global trade signal low, but positive, growth in the third quarter. Global inflation declined to below 2% in August, driven in part by lower energy price inflation, while inflation excluding food and energy remained stable at 2.3%.

Since the Governing Council meeting in September 2019, euro area long-term risk-free rates have increased and the EONIA forward curve has shifted upwards, largely reflecting lower market expectations of another cut in the deposit facility rate before the end of the year. Sovereign spreads have remained broadly stable, with some countries seeing a slight increase during the review period. Equity prices have increased, despite higher discount rates, owing to a falling equity risk premium. In foreign exchange markets, the euro has broadly strengthened in trade-weighted terms.

Euro area real GDP growth was confirmed at 0.2%, quarter on quarter, in the second quarter of 2019, following a rise of 0.4% in the previous quarter. Incoming economic data and survey information continue to point to moderate but positive growth in the euro area in the second half of this year. This slowdown in growth mainly reflects the ongoing weakness of international trade in an environment of persistent global uncertainties, which continue to weigh on the euro area manufacturing sector and are dampening investment growth. At the same time, the services and construction sectors remain resilient, despite some moderation. The euro area expansion is supported by favourable financing conditions, further employment gains in conjunction with rising wages, the mildly expansionary euro area fiscal stance and the ongoing – albeit somewhat slower – growth in global activity.

Euro area annual HICP inflation decreased from 1.0% in August 2019 to 0.8% in September, reflecting lower food and energy price inflation. On the basis of current futures prices for oil, headline inflation is likely to decline slightly further before rising again at the end of the year. Measures of underlying inflation remained generally muted and indicators of inflation expectations stand at low levels. While labour cost pressures have strengthened amid tighter labour markets, the weaker growth momentum is delaying their pass-through to inflation. Over the medium term inflation is expected to increase, supported by the ECB’s monetary policy measures, the ongoing economic expansion and robust wage growth.

Regarding monetary developments, broad money (M3) growth increased to 5.7% in August 2019, after 5.1% in July. M3 growth continues to be backed by bank credit creation, and the narrow monetary aggregate M1 remained the main contributor to broad money growth. Furthermore, the annual growth of broad money and loans to the private sector remained robust as the mechanical contribution of net purchases under the asset purchase programme (APP) faded out and economic momentum weakened. The annual growth rate of loans to non-financial corporations increased to 4.3% in August, from 4.0% in July, while the annual growth rate of loans to households remained unchanged at 3.4%. At the same time, favourable bank funding and lending conditions continued to support loan flows and thereby economic growth. The ECB’s accommodative monetary policy stance will help to safeguard favourable bank lending conditions and will continue to support access to financing, in particular for small and medium-sized enterprises.

Combining the outcome of the economic analysis with the signals coming from the monetary analysis, the Governing Council confirmed that an ample degree of monetary accommodation is still necessary for the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.

On the basis of this assessment, the Governing Council decided to keep the key ECB interest rates unchanged and expects them to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.

The Governing Council confirmed that it will restart net purchases under the ECB’s APP at a monthly pace of €20 billion as from 1 November. It expects them to run for as long as necessary to reinforce the accommodative impact of the ECB’s policy rates, and to end shortly before the Governing Council starts raising the key ECB interest rates.

The Governing Council also intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

The Governing Council reiterated the need for a highly accommodative stance of monetary policy for a prolonged period of time to support underlying inflation pressures and headline inflation developments over the medium term. In particular, the Governing Council’s forward guidance will ensure that financial conditions adjust in accordance with changes to the inflation outlook. In any case, the Governing Council continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner, in line with its commitment to symmetry.

External environment

Global survey indicators of economic growth suggest subdued, but stabilising, economic activity. The global composite output Purchasing Managers’ Index (PMI) excluding the euro area remained in expansionary territory in the third quarter of 2019 and was broadly unchanged compared with the second quarter. Both the manufacturing components and the services components remained stable. Following a protracted period of weakness, the global manufacturing PMI has improved over recent months and returned to expansionary territory, while the global services PMI remained expansionary in the third quarter. Developments were mixed across and within regions. In the third quarter of 2019 the composite output PMI increased in the United States, but decreased in Japan and fell below the expansionary threshold in the United Kingdom. In emerging market economies, the composite output PMI increased in Brazil and India – despite India’s index experiencing a sharp decline to below the neutral threshold in September – and decreased marginally in China and Russia (see Chart 1).

Risks to the global economy remain to the downside amid a further escalation of trade disputes, high uncertainty related to Brexit and a potentially slower recovery in a number of emerging market economies. A continual escalation of trade disputes would likely imply higher adjustment costs in the transition to a new trading regime and possible further disruptions to global supply chains over time. This could, in turn, amplify the impact on economic activity of already-enacted tariffs. Risks related to Brexit remain high. The recovery in a number of emerging market economies that have experienced sharp recessions may be less vigorous than expected. The speed of recovery depends on the extent to which domestic policies address structural impediments to investment and potential growth. A slower recovery in these economies would ultimately translate into more sluggish global growth.

Global financial conditions have remained broadly stable in both advanced and emerging market economies. In September risk sentiment had improved somewhat against the backdrop of renewed expectations of a trade deal between the United States and China, subsiding risks of a disorderly Brexit and strong economic data in the United States. However, risk appetite has since faded again and global equity prices have reversed some of their previous gains. While the Federal Open Market Committee cut interest rates further at its September meeting, weaker than expected economic data has led financial markets to price in further monetary accommodation.

Global trade momentum is expected to remain muted, as higher tariffs are set to come fully into effect at the end of the year. Global trade (excluding the euro area) contracted in the first half of 2019 owing to weak intra-Asia trade, reflecting a slowing down of the Chinese economy and of technology-related trade. Developments in the first half of the year were also influenced by the high volatility in UK imports linked to Brexit-related stockpiling efforts. Short-term indicators of global trade signal low, but positive, growth. Global merchandise imports continued to expand in August in monthly terms, pointing to positive world trade growth in the third quarter. The global PMI for new export orders, while remaining below the neutral threshold, edged up slightly in September following five consecutive months of decline (Chart 2).

Global inflation remains subdued, in spite of tight labour market conditions in major advanced economies. Annual consumer price inflation in the countries of the Organisation for Economic Co-operation and Development (OECD) declined to below 2% in August, driven in part by lower energy price inflation, while inflation excluding food and energy remained stable at 2.3%. Inflationary pressures across major advanced economies remain muted despite the tight labour market conditions, which have so far translated into only moderate wage increases. Overall, underlying inflation pressures are expected to remain subdued over the short and medium term.

Oil prices have remained broadly unchanged amid short-term volatility. On 14 September 2019 a drone attack on Saudi Arabian oil facilities reduced the global oil supply by approximately 6%. The price of oil increased sharply in the aftermath of the attack, but had moved back to the levels seen before the attack by 30 September as Saudi Arabia used spare capacity and inventories to stabilise oil supply amid concerns about global oil demand. Non-oil commodity prices remained mixed, with metal prices having declined and food prices having increased.

In the United States, economic activity remains resilient on the whole. Real GDP expanded at an annualised rate of 2.0% in the second quarter of 2019, following 3.1% in the previous quarter. The deceleration mainly reflects the reversal of temporary factors – related to net exports and private inventories – that supported GDP growth in the first quarter. Overall, a strong labour market, sustained consumer spending and the fiscal impulse from the lifting of spending caps in the fiscal year 2020/21 are expected to support the economy in the near term, more than offsetting the signs of weakness in the manufacturing sector. Financial conditions remain supportive owing to the Federal Open Market Committee’s monetary easing. At the same time, the ongoing trade tensions and a less favourable external environment increase uncertainty about the economic outlook.

In Japan, economic activity remains subdued as weak exports offset robust domestic consumption. Real GDP grew at a quarterly rate of 0.3% in the second quarter, reflecting the rather weak underlying growth momentum. The global economic slowdown had a negative impact on Japan’s export-oriented economy, which dampened business sentiment among large manufacturers. Consumption supported growth, partly owing to frontloading ahead of the increase in the value added tax from 8% to 10% in October 2019. However, the overall personal consumption momentum remains limited amid the adverse impact of bad weather conditions, eroding consumer confidence and muted wage increases. The Bank of Japan kept monetary policy on hold in September and mentioned the need to “re-examine” economic and price developments at the October meeting. Meanwhile, inflation remained subdued, despite a tight labour market. Annual headline CPI inflation eased further to 0.2% in September, while core inflation excluding food and energy slowed to 0.3%.

In the United Kingdom, Brexit uncertainty continues to weigh on the economic outlook. Real GDP declined by 0.2% in quarter-on-quarter terms in the second quarter. This reflected, in large part, an offset to the stronger growth seen in the first quarter, which was mainly supported by stockbuilding in the run-up to the initial Brexit deadline at the end of March. Looking ahead, survey indicators suggest further weakening of consumption, business investment and export growth in the final quarters of 2019, as Brexit-related uncertainty continues to weigh on sentiment. At the same time, further fiscal spending, announced by the Government in September, is expected to put GDP growth in positive territory for the remainder of the year.

In China, GDP growth remains subdued as cyclical headwinds add to the structural slowdown. Real GDP slowed to 6.0% in year-on-year terms in the third quarter of 2019 owing to a decelerating net export contribution. Industrial production and investment softened further in August, highlighting the growing toll on Chinese manufacturers from the trade tensions with the United States. On the upside, the manufacturing PMI returned to above the neutral threshold in September, possibly signalling a bottoming-out of the manufacturing sector. In addition, car sales recovered somewhat in August from the lows in early 2019, but their annual growth remains in negative territory. Overall, China’s growth slowdown is due to both cyclical and structural factors. The structural slowdown is driven by a rebalancing of the economy away from investment, and implies a slowdown of potential growth that mainly reflects a slower pace of capital accumulation and unfavourable demographics. At the same time, cyclical headwinds, reflecting weaker manufacturing activity amid uncertainty relating to the trade tensions, add downward pressure on growth. Fiscal and monetary policy measures remain supportive, with the aim of stabilising growth.

Financial developments

Long-term sovereign yields in the euro area have increased somewhat, albeit with some fluctuations, halting the downward trend that started in late 2018. During the period under review (12 September to 23 October 2019), the GDP-weighted euro area ten-year sovereign bond yield increased by 11 basis points to 0.06% (see Chart 3), on the back of higher risk-free rates amid receding global political tensions. Ten-year sovereign bond yields in the United Kingdom also increased over the review period, to around 0.69%, while the equivalent yields in the United States decreased slightly, to 1.77%.

Euro area sovereign bond spreads relative to the risk-free overnight index swap (OIS) rate remained broadly stable during the review period. The spreads on German, French and Italian ten-year sovereign bonds rose by 3, 5 and 7 basis points respectively to reach ‑0.24%, 0.07% and 1.23%. By contrast, Spanish, Portuguese and Greek spreads declined by 9, 15 and 34 basis points respectively to 0.43%, 0.35% and 1.47%, leaving the GDP-weighted spread for the euro area unchanged at 0.21%.

Broad indices of euro area equity prices rose on the back of a decrease in the equity risk premium. Over the review period equity prices of euro area financials and non-financial corporations (NFCs) increased by 5.2% and 0.2% respectively. The negative effect on equity prices stemming from higher risk-free rates and somewhat lower longer-term earnings expectations was more than offset by a reduction in the equity risk premium, which may partly reflect some relaxation of global trade tensions and of imminent Brexit-related risks.

Euro area corporate bond spreads remained stable over the review period. The gains in equity prices mentioned above were not reflected in movements in corporate bond spreads. Spreads on both investment-grade NFC bonds and financial sector bonds relative to the risk-free rate remain virtually unchanged from the beginning of the review period and stand at 67 and 146 basis points respectively. Overall, although corporate bond spreads are currently higher than the lows reached in early 2018, they remain some 25 basis points below the levels observed in March 2016, prior to the announcement and subsequent launch of the corporate sector purchase programme.

The euro overnight index average (EONIA) and the new benchmark euro short-term rate (€STR) averaged ‑45 basis points and ‑54 basis points respectively over the review period. Both rates are around 10 basis points down on the average levels recorded in August 2019, reflecting the cut in the deposit facility rate (DFR) which took effect on 18 September 2019. The methodology for computing EONIA changed on 2 October 2019; it is now calculated as the €STR plus a fixed spread of 8.5 basis points (see Box 1). Excess liquidity decreased by approximately €74 billion to around €1,687 billion. This decline mainly reflects voluntary repayments in the second series of targeted longer-term refinancing operations (TLTRO II) and, to a lesser extent, an increase in liquidity-absorbing autonomous factors.

The EONIA forward curve shifted upwards over the review period, indicating lower market expectations of another DFR cut. The curve reaches a low of around ‑0.53% in early 2021, which means that a further cut of 10 basis points in the DFR is not fully priced in anymore. Overall, the curve remains below zero for horizons up to 2026, reflecting continued market expectations of a prolonged period of negative interest rates.

In foreign exchange markets, the euro broadly strengthened in trade-weighted terms over the review period (see Chart 4), supported by an increase in interest rate differentials. The nominal effective exchange rate of the euro, as measured against the currencies of 38 of the euro area’s most important trading partners, appreciated by 0.6%. This reflects a strengthening of the euro against major currencies, including the US dollar (by 1.5%), the Chinese renminbi (by 1.3%), the Japanese yen (by 2.1%) and the Swiss franc (by 1.0%). The euro also appreciated vis-à-vis the currencies of most emerging market economies. Over the same period, the euro weakened against the pound sterling (by 2.8%) amid news pointing towards an increased likelihood of a smooth Brexit, and also depreciated slightly against the Polish zloty (by 1.2%), the Czech koruna (by 0.7%) and the Hungarian forint (by 0.5%).

Economic activity

Real GDP growth slowed in the second quarter of 2019 on the back of weak trade. Output in the euro area rose by 0.2%, quarter on quarter, in the second quarter of 2019, following growth of 0.4% in the first quarter (see Chart 5). Domestic demand continued to contribute positively to GDP growth, whereas net trade made a negative contribution. Changes in inventories provided a neutral contribution (close to zero). Economic indicators point to ongoing, but slow, growth in the second half of 2019.

Euro area labour markets remained resilient. Employment increased by 0.2% in the second quarter of 2019, down from 0.4% in the first quarter, and in line with the moderation in output growth. Employment growth was broad-based across countries and sectors. Employment has risen for 24 consecutive quarters since mid‑2013, with the number of people employed increasing by about 11.2 million. Hourly productivity growth was zero in quarter-on-quarter terms in the second quarter of 2019, after a small increase in the first quarter.

Looking ahead, recent data and survey indicators continue to point to positive but moderate employment growth. The euro area unemployment rate stood at 7.4% in August, down from 7.5% in July. Short-term survey indicators, despite declining from the high levels recorded in 2018, suggest that near-term employment growth will continue to be positive, supported by the services sector.

Rising employment continues to support household income and consumer spending. Private consumption rose by 0.2%, quarter on quarter, in the second quarter of 2019, following somewhat stronger growth in the previous quarter. Household real disposable income has been largely insulated from the recent economic slowdown. Annual growth of real gross disposable income rose from 2.1% in the first quarter to 2.2% in the second quarter. Overall, employment growth has remained resilient during the slowdown, supporting labour income. In addition, lower direct taxes and social security contributions, reflecting fiscal measures in a number of euro area countries, have contributed positively to households’ purchasing power. The saving ratio increased further in the second quarter of 2019, as income growth outpaced consumption growth.

Looking ahead, private consumption should continue to grow steadily. Recent data on the volume of retail sales and new passenger car registrations point to somewhat lower consumption growth in the third quarter of 2019 compared with the second quarter. However, other indicators support the picture of steady consumption dynamics. Consumer confidence, which started to decline at the end of 2017, has stabilised in the course of 2019 and stood in October close to the level recorded at the beginning of the year. The latest survey results also signal favourable labour market conditions, which should continue to support household income and consumer spending.

Business investment is expected to remain subdued in a context of elevated uncertainty and low profit margins, while nevertheless supported by favourable financing conditions. Non-construction investment rose by 11%, quarter on quarter, in the second quarter of 2019. This was largely due to a strong increase in Ireland, reflecting the openness and volatile capital flows of the Irish economy. Incoming data suggest ongoing but moderate business investment growth in the euro area in the near term. Industrial production of capital goods stood on average in July and August 0.5% above its average level in the previous quarter. However, industrial confidence in the capital goods producing sector declined in September, in the context of intensifying trade disputes and geopolitical risks. Weak firm profit margins, on a downward trend since mid‑2017, also suggest a drag on business investment growth. Moreover, the level of capacity utilisation in manufacturing, in continuous decline since the first quarter of 2018, reached almost its historical average in the third quarter of this year after more than two years above it. On a more positive note, favourable financing conditions, reflected in the access to credit for non-financial corporations, will continue to support business investment.

Housing investment growth is expected to remain weak in the near term. Quarterly growth in housing investment came to a halt in the second quarter of 2019, after 1.4% in the previous quarter, posting the lowest outcome in four years. Recent short-term indicators and survey results suggest weak momentum in the third quarter, although they remain above historical averages. The European Commission’s construction confidence indicator for the third quarter points to positive, albeit decelerating, momentum. Similarly, the Purchasing Managers’ Index (PMI) for construction output in the third quarter stood below the average level recorded in the previous quarter and indicated broadly flat growth in the construction sector.

Extra-euro area exports of goods and services stagnated and imports rose in the second quarter, while intra-euro area trade weakened further. After a short recovery in the first quarter, extra-euro area goods and services exports stagnated in the second quarter of 2019, with a reversal of stockbuilding in the United Kingdom. Developments in intermediate and capital goods in particular weighed on extra-euro area exports. Extra-euro area imports of goods and services increased on account of strong growth in Irish imports. Intra-euro area exports and imports both weakened in the second quarter after a soft rebound in the first quarter. Looking at monthly figures, euro area goods trade was broadly stable at weak levels in August in nominal terms, with extra-euro area and intra-euro area trade following divergent paths. While extra-euro area goods exports recovered somewhat in August (increasing by 0.4% month on month, after 0.2% in July), extra-euro area goods imports contracted by 1.2%. Intra-euro area goods exports continued to weaken (by 1.6% month on month), while imports also fell, by 0.4%. Leading indicators point to continued anaemic growth of extra-euro area exports. The PMI for new manufacturing export orders and the European Commission’s indicator on the assessment of export order books fell again in September. At the same time, shipping indicators show signs of bottoming out at very low levels.

Incoming data and survey results point to moderate but positive economic growth in the second half of 2019. This growth pattern can be primarily attributed to weak global trade and prolonged uncertainties. For instance, industrial production stood on average in July and August below its average level in the second quarter, thus pointing to a further quarter-on-quarter fall in production in the third quarter. As regards more timely survey data, in the third quarter both the European Commission’s Economic Sentiment Indicator and the composite output PMI were below their respective average levels in the second quarter. For both surveys, the decline was more pronounced for the manufacturing sector than the services sector (see Box 2 for a more in-depth analysis of the relationship between developments in the services and manufacturing sectors).

Looking ahead, the euro area expansion will continue to be supported by favourable financing conditions. In addition, growth should be underpinned by further employment gains, rising wages and the ongoing – albeit somewhat slower – expansion in global activity. The results of the latest round of the ECB Survey of Professional Forecasters, conducted in early October, showed that the private sector GDP growth forecasts for 2019, 2020 and 2021 had been revised down compared with the previous round, conducted in early July.

The risks surrounding the euro area growth outlook remain on the downside. In particular, these risks pertain to the prolonged presence of uncertainties, related to geopolitical factors, rising protectionism and vulnerabilities in emerging markets.

Prices and costs

HICP inflation decreased to 0.8% in September 2019, down from 1.0% in August 2019. This decrease in the inflation rate reflected a decrease in energy and food inflation. Energy inflation further unwound from the high rates seen in late 2018 and was negative in September.

Measures of underlying inflation remained generally muted and continued to move sideways. HICP inflation excluding energy and food increased to 1.0% in September, up from 0.9% in August, and remains affected by methodological changes.^[1] HICP inflation excluding energy, food, travel-related items and clothing stood at 1.1% in September, where it has remained since May. Signals from other measures of underlying inflation, including the Persistent and Common Component of Inflation (PCCI) indicator and the Supercore indicator,^[2] also pointed to a continuation of the broad sideways movement now seen for several quarters.

Pipeline price pressures for HICP non-energy industrial goods weakened slightly. The annual rate of change in producer prices for domestic sales of non-food consumer goods was 0.8% in August, unchanged from July. The annual rate of change in import prices for non-food consumer goods saw a moderate decrease to 0.4% in August from 0.6% in July. At the earlier stages of the supply chain, producer price inflation for intermediate goods weakened marginally, declining to ‑0.4% in August from ‑0.3% in July. Similarly, import price inflation for intermediate goods decreased to ‑0.3% in August from 0.0% in July. Global producer price inflation excluding energy also declined further to 2.0% in August from 2.5% in July and was below its long-term average of 2.3%.

Wage growth remained robust. Annual growth in compensation per employee stood at 2.3% in the first quarter of 2019 and 2.2% in the second quarter of 2019. The figures for the first and second quarters of 2019 were affected by a significant drop in social security contributions in France due to legislative changes.^[3] Annual growth in wages and salaries per employee, which excludes social security contributions and is hence not affected by the legislative change in France, was 2.5% in the second quarter, compared with 2.6% in the first quarter and 2.3% on average for the previous year. Annual growth in compensation per employee has stabilised since mid‑2018 at a level slightly above its historical average of 2.1%.^[4]

Market-based indicators of longer-term inflation expectations have remained subdued while survey-based expectations decreased slightly. The five-year forward inflation-linked swap rate five years ahead stood at 1.20% on 23 October 2019, broadly in line with the level which prevailed in early September and eight basis points above a new all-time low of 1.12% reached on 3 October 2019. The market-based probability of deflation remains contained, despite exhibiting a continued upward trend over the review period. At the same time, the forward profile of market-based indicators of inflation expectations continues to point to a prolonged period of low inflation. The results of the ECB Survey of Professional Forecasters (SPF) for the fourth quarter of 2019 show point forecasts for annual HICP inflation averaging 1.2%, 1.2% and 1.4% for 2019, 2020 and 2021 respectively. These results represent downward revisions of 0.1 percentage points for 2019 and 2021 and of 0.2 percentage points for 2020 compared with the previous survey round. The revisions are mainly attributable to lower oil prices, a weaker growth outlook, downward surprises in recent inflation outcomes and heightened uncertainties regarding trade and Brexit. Average longer-term inflation expectations remained at 1.7%.

Money and credit

Broad money growth remained robust in August. The annual growth rate of M3 increased to 5.7% in August 2019, up from 5.1% in July, on account of a positive base effect (see Chart 9). M3 growth continued to be supported by the lower opportunity cost of holding M3, while the positive contribution of net purchases under the APP to annual M3 growth faded out. The narrow monetary aggregate M1, which includes the most liquid components of M3, continued to be the main contributor to broad money growth. With an annual growth rate of 8.4% in August 2019, up from 7.8% in July, it was around two percentage points above its local trough in January 2019. Among M1 components, the annual growth of currency in circulation remained solid, though not exceptionally high by historical standards, pointing to no pervasive substitution into cash.

External monetary flows stabilised and credit to the private sector remained the main source of money growth. The fading APP impulse to M3 growth (see the red bars in Chart 9) has been largely offset by positive contributions from credit to the private sector (see the blue bars in Chart 9). In addition, external monetary inflows (see the yellow bars in Chart 9) have contributed positively to M3 growth since October 2018. This development reflects increased interest among foreign investors in euro area assets. The contribution to M3 growth from credit to general government from euro area monetary financial institutions (MFIs) excluding the Eurosystem (see the light green bars in Chart 9) remained marginally negative. Likewise, the drag from longer-term financial liabilities on annual broad money growth remained small (see the dark green bars in Chart 9).

The annual growth of loans to the private sector was broadly unchanged. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) increased to 3.8% in August 2019, from 3.7% in July (see Chart 10). This development was mainly due to the increase in the annual growth rate of loans to NFCs to 4.3% in August, from 4.0% in July, in part due to a one-off factor. Loans to households grew at an annual rate of 3.4% in August 2019, unchanged from July. In this respect, the turning point in September 2018 for loan growth to NFCs (when it peaked at 4.3%) is in line with its lagging cyclical pattern with respect to real economic activity and the 2018 slowdown in aggregate demand. Based on the same pattern, past improvements in fixed investment, which accounts for a large share of the growth in lending to NFCs, stabilised loan developments. Overall, loan growth continued to benefit from historically low bank lending rates and the overall favourable supply of bank loans, as also evidenced by the recent results of the euro area bank lending survey. In addition, banks have made progress in consolidating their balance sheets.

According to the October 2019 euro area bank lending survey , credit standards for loans to enterprises and households for house purchases eased slightly. Risk perceptions related to the economic outlook continued to make a tightening contribution, whereas in the previous round banks had expected unchanged credit standards (banks’ internal guidelines or loan approval criteria). Despite ongoing pressure from competition, and mainly driven by wider margins on riskier loans, credit terms and conditions (the actual conditions laid down in the loan contract) for loans to NFCs and housing loans tightened in the third quarter of 2019. Benefiting from the low interest rate environment, demand for loans continued to increase for both housing loans and consumer credit. Favourable housing market prospects also continued to support demand for housing loans. At the same time, demand remained broadly stable for loans to enterprises. This happened because, for the first time since 2013, inventories and recourse to working capital contributed negatively to loan demand. Furthermore, euro area banks indicated that the APP was continuing to make a positive impact on their lending volumes, liquidity position and market financing conditions, while contributing negatively to their profitability. Banks also reported that the negative deposit facility rate had contributed to an increase in lending volumes and a decrease in lending rates across all loan categories, but had had a negative impact on their net interest income.

Lending rates have continued to moderate in line with market reference rates, thereby supporting euro area economic growth. In August 2019 the composite bank lending rates for both loans to NFCs and housing loans reached new historical lows, at 1.52% and 1.56% respectively (see Chart 11). Competitive pressures and more favourable bank funding costs dampened lending rates for loans to euro area NFCs and households. Overall, composite bank lending rates for loans to NFCs and households have fallen significantly since the ECB’s credit easing measures were announced in June 2014. Between May 2014 and August 2019 composite lending rates on loans to NFCs and households fell by around 140 and 135 basis points, respectively. The reduction in bank lending rates for loans to NFCs, including those for loans to small firms (assuming that very small loans of up to €0.25 million are primarily granted to small firms) was particularly significant in those euro area countries that were most exposed to the financial crisis. Overall, this indicates a more uniform transmission of monetary policy to bank lending rates across euro area countries and across firm sizes.

In August 2019 net issuance of debt securities by euro area NFCs was slightly negative, but this did not stop the upward trend in annual flows that started at the beginning of 2019. The latest ECB data indicate that, on a net basis, the total flow of debt securities issued by NFCs was slightly negative in August 2019. However, the negative reading in August is in line with the series’ seasonal pattern and is affected by the redemption of debt securities issued by a single NFC in one Member State. Overall, the annual flows of debt securities continued to increase, returning to the levels recorded at the end of 2017 (see Chart 12). Available market data suggest that net issuance of debt securities – by both investment grade and high-yield firms – remained quite strong at the end of the third quarter of 2019. In August 2019 total net issuance of quoted shares by NFCs was negative, thereby continuing the downward trend which had started at the end of 2018 and was only broken temporarily in April 2019. Negative issuance of NFC listed shares appears to have been related to both the weakness in merger and acquisition (M&A) activity and the use of share buy-backs, including cancellations, in corporate balance sheet management.

Financing costs for euro area NFCs are estimated to have declined since August 2019. The overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, stood at 4.7% in August 2019, but is projected to have declined more recently to levels close to those recorded in the spring and early summer of 2019. As a result, the cost of financing in October 2019 is estimated to be 15 basis points above the historical low of April 2019, but far below the levels observed in the summer of 2014. The estimated decline in the cost of financing since August 2019 is entirely accounted for by the decline in the cost of equity, which is only partially balanced by a slight increase in the cost of market-based debt, which hit its historical low in August 2019. Since August the cost of equity has declined because of lower risk premia, reflecting, among other things, some relaxation of global trade tensions and Brexit-related risks. The slight increase since August in the cost of market-based debt reflects the increase in the long-term risk free rate, which may be related to, among other factors, a reduction in market expectations of further interest rate cuts.

Boxes

Goodbye EONIA, welcome €STR!

Prepared by Pascal Nicoloso and Vladimir Tsonchev

On 2 October 2019, the ECB began publishing the new overnight unsecured benchmark rate for the euro area, the euro short-term rate or €STR. The rate is computed entirely based on transactions in euro with financial counterparties as reported under the Money Market Statistical Reporting (MMSR) Regulation (Regulation (EU) No 1333/2014) and reflects the wholesale euro unsecured borrowing costs of euro area banks^[5], in contrast to EONIA that measured interbank lending. The rate is published on each TARGET2 business day at 08:00 CET and is based on transactions conducted and settled on the previous TARGET2 business day. A data sufficiency policy ensures that the rate is representative by requiring that (a) at least 20 of the banks currently reporting under the MMSR Regulation should submit contributions and (b) the five largest reporting agents should not report more than 75% of a given day’s turnover.

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Developments in the services sector and its relationship with manufacturing

Prepared by Magnus Forsells, Neale Kennedy and Lisa Marie Timm

This box looks at the euro area services sector and its relationship with manufacturing, focusing particularly on the extent to which the services sector could be affected by the recent slowdown in manufacturing. Economic growth in the euro area has been slower in recent quarters, mainly reflecting the impact on the euro area manufacturing sector of the ongoing weakness in international trade in an environment of prolonged global uncertainties. However, activity levels in the services sector have so far been relatively robust in the face of this downturn in manufacturing. This is likely to stem from the resilient developments in domestic demand, supported by the very accommodative monetary policy stance, which continues to support labour markets and create favourable financing conditions. The services sector is an important driver of overall economic activity in the euro area, constituting over 70% of total value added.

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A stylised tracer for labour market cycles in the euro area based on assessments by corporate executives

Prepared by Vasco Botelho

This box assesses the current cyclical position of the euro area labour market by means of a stylised tracer for employment and output fluctuations using the Purchasing Managers’ Index (PMI) survey data. The PMI is a set of monthly indicators which, owing to their timeliness and monthly frequency, can be used to predict movements in the growth rate of key macroeconomic variables, such as employment and real GDP. However, the monthly PMI data can also be very volatile over time, as they contain information not only on structural factors and the cyclical position of the economy, but also on assessments by corporate executives regarding the immediate reactions of their firms to idiosyncratic events over time. This latter component of the PMI data is likely to be affected by possible measurement errors or by information asymmetries. As such, a stylised labour market tracer^[6] is constructed by applying a low-pass filter to the underlying monthly PMI data on employment and output, with a view to smoothing the PMI data and isolating the relevant information in order to assess the current cyclical position of the labour market.

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Price-setting behaviour: insights from a survey of large firms

Prepared by Richard Morris and Rupert de Vincent-Humphreys

This box summarises the findings of an ad hoc ECB survey of leading euro area firms about their price-setting behaviour. Firms’ price-setting strategies are crucial pointers for understanding how prices adjust to shocks and, therefore, implicitly the effect of monetary policy on inflation. Surveys are a useful tool for collating evidence in this regard, as illustrated, in particular, in the seminal work of Blinder^[7]. Survey evidence of the price-setting behaviour of firms in the euro area was collated some time ago in the context of the Eurosystem Inflation Persistence Network (see Fabiani et al., 2005^[8]). Our survey draws on elements of those earlier surveys, while also gathering more qualitative evidence concerning the various dimensions of price-setting.

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Article

Trends in central banks’ foreign currency reserves and the case of the ECB

Prepared by Livia Chiţu, Joaquim Gomes and Rolf Pauli

This article begins with a review of the global trends in central banks’ foreign currency reserve holdings in terms of their size, adequacy and composition, and follows on to examine the ECB’s foreign currency reserves. Just as the reasons for holding reserves have changed over time and across countries, so too have the size and composition of those reserves. Views on appropriate adequacy metrics have also changed. Global foreign currency reserves grew markedly after the Asian financial crisis of the late 1990s, with emerging markets accumulating large reserves to self-insure against potential shocks. In some cases, the growth in reserves was a by-product of export-led growth strategies. While global foreign currency reserves have traditionally been invested primarily in US dollar-denominated financial assets, in recent years holdings have become more diversified in terms of both currency and asset classes.

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Statistics

Statistical annex