Peter Praet: The macroeconomic situation and monetary policy in
the euro area
Introductory remarks by Mr Peter Praet, Member of the Executive Board of the European Central
Bank, at the MNI Connect Roundtable and OMFIF lunch discussion, London, 23 February 2017.
* * *
Today I will discuss the current economic situation in the euro area, the outlook and the
implications for monetary policy.
As a central bank with a clear price stability mandate, we need to ultimately judge economic
developments with regard to their implications for price stability. Inflation has fallen short of the
ECB's medium-term inflation goal of below, but close to, 2% since the beginning of 2013. But
recently, with the fading of the declines in energy prices that restrained inflation, headline inflation
has moved up quite sharply. In the near future, we will have to assess how the forces that are
driving prices today can influence the outlook for price stability in the medium term and help
durably stabilise inflation around our goal.
The economic recovery will help support domestic price pressures. Indeed, the upswing is
continuing at a moderate, but firming pace, and is broadening gradually across sectors and
countries. Real GDP growth has expanded for 15 consecutive quarters, growing by 0.4% during
the final quarter of 2016 in the euro area according to the Eurostat flash estimate. Economic
sentiment is at its highest level in nearly six years and unemployment is back to single-digit
figures. Looking beyond the euro area, the global economy, too, is showing increasing signs of a
cyclical upturn.
The euro area economy has been resilient in the face of a number of risks and uncertainties at
global level. One example of its improving resilience is the fact that domestic demand is now the
mainstay of real GDP growth. Previously, growth in the euro area was closely correlated with the
strength of international trade, but that relationship has weakened recently; last year's growth
would not have been possible in view of the lacklustre international conditions.
Our monetary policy measures have been a key contributor to these positive developments in the
euro area economy. The comprehensive set of measures introduced since June 2014 has
worked its way through the financial system, leading to a significant easing of financing
conditions for consumers and firms. Together with improving financial and non-financial sector
balance sheets, this has strengthened credit dynamics and supported domestic demand.
Since June of that year, bank lending rates for both euro area households and non-financial
corporations have fallen by over 110 basis points. Lending rates for small and medium-sized
enterprises, which provide two-thirds of total private sector employment in the euro area, have
declined by over 180 basis points.
The sharp reduction in bank lending rates has been accompanied by easier access to funding,
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as recent surveys have shown. These positive developments have been supported by the
second series of targeted longer-term refinancing operations, as a result of which banks are
passing on the favourable funding conditions to their customers. Moreover, these improvements
are not limited to interest rates: bank lending volumes have also been gradually recovering since
early 2014. Market-based funding conditions, too, have improved significantly in response to the
corporate sector purchase programme launched in June 2016.
We expect the euro area economy to recover further. Private consumption growth and the
continued cyclical recovery of business investment are expected to support domestic demand.
Underpinning consumption are the improvements in labour market conditions, with
unemployment steadily falling despite a rise in participation. These developments increase
households' real disposable income, which boosts the spending of established employees, who
are confident about their earnings prospects, as well as new employees. Business investment is
also expected to continue recovering amid support from better corporate profitability.
As for price developments, after hovering at levels well below 1% for three years, with occasional
dips into negative territory, euro area headline inflation edged higher towards the end of last year
and reached 1.8% in January. This upward movement of inflation mainly reflects increases in
energy and food prices. By contrast, underlying inflation - which relates more to domestic price
pressures - continues to remain very subdued and has yet to show clear signs of a more
dynamic upward movement. For example, the annual rate of HICP inflation excluding food and
energy has mostly remained below 1% since late 2013.
So why is underlying inflation still slow to pick up? And will further monetary accommodation
really facilitate a durable return of inflation back to a level that is below, but close to, 2% over the
medium term? To answer these questions we need to acknowledge that monetary policy
controls medium-term inflation through two main channels: by influencing cyclical conditions and
by pinning down expectations.
As you see, I have omitted from my list the sort of "structural factors" that have figured
prominently in the recent debate on secular stagnation and have been invoked - in that context -
as an explanation for low inflation. This is not to say, however, that forces that are structural in
nature and unrelated to monetary policy cannot influence the inflation trajectory for what might be
a protracted period of time. For example, a supply shock that reduces firms' pricing power by
either weakening barriers to entry or by increasing price transparency can result in a mark-up
squeeze for firms, triggering a drawn-out process of disinflation that can last for years. But once
firms have adjusted to the new competitive landscape and their selling prices stabilise around a
lower equilibrium level, the mark-up squeeze will cease to drive aggregate inflation down. Inflation
- once more - will start fluctuating around the level that the central bank chooses for the medium
term. The traditional Phillips curve connection between current inflation, expectations of future
inflation and the cycle will re-assert itself.
Eurosystem staff analysis confirms that the Phillips curve remains alive and well in the euro
area. Today, that empirical regularity says that, while being on a gradual reabsorption path, some
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remaining slack continues to restrain underlying inflation in the euro area. By ensuring
accommodative financing conditions, monetary policy supports domestic demand, which
creates the environment necessary for the mobilisation of idle resources to bring output back to
its potential level. This will lead to a build-up of price pressures and ultimately pull inflation up.
Monetary policy also plays a pivotal role in anchoring inflation expectations, which are an
important explanatory factor of actual inflation. After all, inflation expectations determine the
intercept of the Phillips curve.
Under normal conditions, longer-term inflation expectations should remain unaffected by
transitory shocks that typically dissipate over the medium term, such as those related to oil
prices. However, recurrent shocks that lead to either a prolonged period of above- or
belowtarget inflation can be misinterpreted as a lasting change in underlying inflation. In my earlier
example, if the central bank tolerates a prolonged period of declining mark-ups, and headline
inflation is weaker than the central bank's target, then the Phillips curve in all likelihood will
reanchor around a lower medium-term inflation level. In the worst scenario, self-reinforcing spirals
may result, as firms and households start to extrapolate from past inflation outcomes. Their
expectations become self-fulfilling through adaptive wage- and price-setting behaviour.
Today, an important element keeping underlying price pressures subdued is muted wage
dynamics, which are shaped by many factors. At this stage, there is still a significant degree of
labour market slack and weak productivity developments that keep a lid on wage growth.
Furthermore, the process of setting wages is to some extent backward-looking in a number of
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euro area countries, reflecting formal and informal indexation mechanisms. Additionally, the
timing of wage negotiations plays a role. Wage negotiations often have a multi-year horizon;
given that headline inflation remained below 1% for 38 consecutive months until December of
last year, it is going to take some time for an increase in headline inflation to translate into
second-round effects on broader inflation. Moreover, weak wage growth could also reflect
previous downward wage rigidities: difficulties in reducing wages during the crisis may result in a
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slower upward adjustment of wages as labour market conditions improve.
Just as our monetary policy measures have effectively underpinned the economic recovery, they
have also prevented the prolonged period of disinflationary pressures from turning into a
sustained period of deflation. In fact, the accommodative monetary policy stance appears to be
increasingly visible in developments in inflation expectations, which are showing signs of reversal
from previous flat or negative trends, while also reflecting changes in the global environment. For
example, market-based measures of euro area inflation expectations have been trending
upwards since early September, while survey-based measures of inflation expectations continue
to signal an increase of inflation.
So while we are certainly seeing a firming, broadening and more resilient economic recovery that
will in time translate into a durable increase in inflation, we cannot ignore the fact that one of the
main forces behind the upward inflation trajectory that we expect to see over the medium term is
monetary policy itself. The economic recovery and the outlook for price stability are still
predicated on the very favourable financing conditions that to a large extent depend on continued
monetary policy support.
Therefore, we need to look through the volatility in short-term data resulting from transitory
factors in order to assess whether progress towards a durable and self-sustaining convergence
in the path of inflation has been sufficient.
With this aim in mind, the Governing Council reaffirmed at its last meeting that the asset
purchase programme will continue until the end of December 2017, or beyond, if necessary, and
in any case until we are sufficiently confident that inflation converges towards levels below, but
close to, 2% over the medium term and that this process will not reverse under less supportive
monetary policy conditions.
Of course, monetary policy cannot be the only game in town: other policymakers must display
the same commitment to ensuring a sustainable economic recovery. Structural reforms can play
a key role in turning the cyclical recovery into a structural recovery and the current low interest
rate environment makes it politically and economically easier to implement them. Such reforms,
if carried out now, will help to promote favourable economic conditions down the road.
1
See ECB Bank Lending Survey, January 2017, and ECB Survey on the Access to Finance of Enterprises in the
euro area, April 2016 to September 2016.
2
For more detailed discussion of the Phillips curve and low inflation in the euro area economy, see Praet, P.
"Maintaining price stability in the euro area", remarks at the 15th Handelsblatt Jahrestagung "Zukunftstrategien
für Sparkassen und Landesbanken", Berlin, 2 February 2017.
3
For further discussion, see "Recent wage trends in the euro area", Box 2, ECB Economic Bulletin 2016/03.
4
See, for example, "Wage dynamics amid high euro-area unemployment", Deutsche Bundesbank Monthly
Report, December 2016.