Gabriel Makhlouf: The economic outlook
Remarks by Mr Gabriel Makhlouf, Governor of the Central Bank of Ireland, at Market News
International, 11 June 2020.
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Accompanying slides of the speech.
Introduction
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Good afternoon. It is a pleasure to speak to you today.
In my opening presentation I would like to first discuss the developments in the euro area
economy, the economic outlook for the euro area, and give some views on the recent decisions
taken by Governing Council of the ECB. I will then give an overview of how the pandemic has
impacted the Irish economy and financial sector in Ireland and discuss some pre-existing risks,
like the UK's departure from the EU.
***
Developments and economic outlook for the euro area economy
It is now clear that the COVID-19 pandemic has caused a very substantial shock to the global
economy. For the euro area, GDP had an unprecedented decline of 3.6% in the first quarter of
this year, which is a sharper contraction than was seen during the global financial crisis. (Figure
1: Euro area GDP growth (quarter-on-quarter, %))
Higher frequency PMI data shows the sharp contraction has continued through the second
quarter. There has also been a sharp deterioration in labour markets across the euro area,
feeding through to incomes and to consumption patterns. These developments, among others,
have caused sharp downward revisions in the recent macroeconomic projections for the euro
area, released by Eurosystem staff. (Figure 2: Euro area Purchasing Managers' Indices)
The latest projections for 2020 to 2022, have changed greatly compared to those released just
three months ago.
It is not only the numbers that look different in this round of projections; there has also been a
change in how the uncertainty surrounding the key forecasts is presented. Previously, we used
historical data but these cannot reflect the unprecedented current economic uncertainty we are
experiencing. Instead, a scenario analysis is provided as a better way to show potential alternate
paths for the economy. (Figure 3: Eurosystem staff macroeconomic projections)
In the baseline scenario, there is an assumption of some resurgence in infections over the next
couple of quarters that leads to ongoing containment measures, although not as stringent as the
initial ones. The economy is expected to "re-open" gradually, in phases, through a post-lockdown
transition period, which ends by the middle of 2021. At this point, it is also assumed that medical
solutions to contain the virus become available.
Two alternative scenarios serve as an illustration of the wide range around the baseline scenario.
The mild scenario assumes that the virus is successfully contained in the post-lockdown
transition period and there is no resurgence in infections. Thus, the economy recovers gradually
towards normal levels of activity. In contrast, the virus makes a strong resurgence under the
severe scenario and strict lockdown measures are therefore extended. These are assumed to
be more damaging to economic activity than under the baseline scenario with lower real GDP
growth and more subdued inflation. It is worth noting that the effect of the pandemic on inflation
dynamics is ambiguous due to competing effects, which could cause inflation to increase or
decrease. The downturn in the economy will result in substantial economic slack, which would
tend to weaken inflation dynamics. But the pandemic has also caused supply chains to be
constrained and this may continue, which would tend to drive prices up. Overall, it is likely that
that the substantial economic slack will dominate and result in weak inflation dynamics over the
medium-term. (Figure 4: Eurosystem staff macroeconomic projections - scenarios)
In general, the Eurosystem baseline projections for growth are below those of other
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forecasters with the exception of the OECD forecasts that were published on Wednesday. All
forecasters acknowledge the prevailing very high levels of uncertainty. The OECD produces two
scenarios. In their "single-hit" scenario, the current containment measures are assumed to be
largely successful in containing the outbreak allowing a gradual recovery in growth and
employment over the remainder of this year and in 2021. In the "double-hit" scenario, there is a
second peak of infections in the autumn. The level of GDP in 2021 in the ECB baseline scenario
is roughly the same as the OECD's "single-hit" scenario.
***
The June monetary policy decision
This provided the context to last week's meeting where I joined my colleagues on the Governing
Council of the ECB for one of our regular meetings where we set monetary policy for the euro
area. We took a number of decisions to ensure that the stance is appropriate to achieve our
price stability objective over the medium-term. These decisions reflect the unprecedented
downturn in the economy and the deterioration in the outlook for growth and inflation. The
monetary policy stance must maintain favourable financing conditions for all sectors of the
economy and across countries. Firm demand for credit is particularly strong now given the
significant liquidity issues many firms face due to the pandemic. An unwarranted tightening of
financial conditions, whereby lending to the real economy becomes constrained, is something
we want to avoid.
The first decision taken by the Governing Council was to increase the envelope of asset
purchases under the Pandemic Emergency Purchase Programme (PEPP) by €600bn to
€1,350bn. The PEPP will contribute to an easing of the monetary policy stance and will help to
main supportive financing conditions for the real economy. These purchases will be conducted in
a flexible manner over time, across asset classes and among jurisdictions, to avoid risks to the
smooth transmission of monetary policy.
The horizon for the asset purchases under PEPP has been extended at least until the end of
June 2021. The Governing Council will continue with these purchases until it judges that the
COVID-19 crisis phase is over. When securities purchased under PEPP mature, the principal
payments will be reinvested at least until the end of 2022. The Governing Council will adjust the
monetary policy stance further, if necessary.
***
The Irish economy
Turning to the domestic economy, it is remarkable to see how quickly the prospects for the Irish
economy have changed.
For example, in February this year, we published our first Quarterly Bulletin (QB) of the year. The
Irish economy grew strongly in 2019. Given the measurement issues with GDP in Ireland, we
tend to focus on underlying domestic demand and we were forecasting a growth rate in this
measure of 3.7 per cent for 2020. The data also suggested that the public finances were
improving, with the general government balance in surplus for 2019. We were also forecasting
that the unemployment rate to average 4.8 per cent in 2020. How times have changed. (Figure 5:
Central Bank of Ireland QB1 2020 Forecasts)
In our second QB of the year, published in April, it was not possible to produce conventional
forecasts due to the extent of the unknowns. Instead we produced a scenario analysis which
relied heavily on assumptions and analysis of very high-frequency data, where available, to
understand the magnitude of the decline in economic activity. That projection noted that
COVID19 had triggered an extremely severe economic shock that was fundamentally different in nature
and scope from types of shocks previously witnessed. At present, the Bank is preparing to
publish its latest projections in early July in line with the ECB scenarios. (Figure 6: Central Bank
of Ireland QB2 2020 Scenario Analysis)
Since the publication of April's Quarterly Bulletin, the downturn in economic activity has been
severe. National Accounts data show that consumption declined by 4.7 per cent in the first
quarter of the year. While the phased reopening of the economy has started, a further significant
decline is expected for the second quarter.
The decline in employment in March and April is unprecedented, with all sectors of the economy
affected. Job losses came in waves, with 515,000 people now in receipt of the Pandemic
Unemployment Payment, with a further 380,000 supported by the temporary wage subsidy
scheme in their last pay packet. (Figure 7: Numbers in receipt of state payments by scheme)
A standout aspect of the economic impact of the pandemic has been the pace at which
economic conditions nosedived from the onset of the virus. The measures put in place to impede
the transmission of the virus, such as curtailment or full closure of activity in some sectors and
limits on travel and social gatherings, had an immediate effect on economic activity. For analysts
and policymakers, this presents a challenge since many key indicators used to monitor
economic activity are only released with a lag. For example, official Irish National Accounts data
on consumer spending and investment for the period April-June 2020 is not due to be published
until September 2020.
To provide an up-to-date assessment of economic conditions in real time, the Central Bank has
developed a Business Cycle Indicator (BCI). The BCI is a monthly summary indicator of overall
economic conditions estimated from a larger dataset of high-frequency releases. This week
Central Bank economists published research containing the latest update of the BCI. The
analysis shows that the BCI dropped to an unprecedented low at the peak of the containment
measures in April, as shown in Figure 4. The decline in the indicator in April suggests that the
initial economic impact of the COVID-19 pandemic was both sharper and deeper than the
financial crisis of 2008/09.
The latest preliminary estimate of the BCI for May 2020 points to some stabilisation in economic
conditions, but the overall level of activity remains substantially below that observed prior to the
COVID-19 outbreak.
***
Of course, while the shock from COVID-19 has been extremely severe and has rightly been the
focus for policy makers around the world, the risks that existed before the pandemic have not
disappeared. I want to mention two: the UK's departure from the EU and market-based finance.
The UK's departure from the EU
Following the UK's exit from the EU on 31 January 2020, negotiations are currently underway to
try and conclude a Free Trade Agreement (FTA) between the parties before the end of 2020. If
there is no agreement on a new FTA and no extension of the current transition period then the
EU and UK could move to trading on WTO terms from January 2021. In previous analysis, the
Central Bank has discussed the risks to the economy from future potential post-Brexit trade
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arrangements. Given the extensive linkages between Ireland and the UK, the UK's withdrawal
from the EU will affect the Irish economy through a range of channels.
With the UK exiting the EU Customs Union and Single Market, trade between Ireland and the UK
will not be as frictionless as today. And while the successful conclusion of an FTA could
eliminate tariffs on most EU-UK trade, other frictions would arise that would make trade in both
goods and services more cumbersome. These non-tariff barriers include the possible need to
manage new import and export formalities, including customs and security declarations. Trade in
agri-food products - particularly important in an Irish context - could also be subject to new
additional checks and inspections. In the case of a WTO arrangement these effects on trade
would be compounded by the imposition of tariffs. It is important to note that new tariff and
nontariff barriers would negatively affect both importing and exporting. Over 20 per cent of imports of
Irish-owned firms are either completely or very highly reliant on imports coming from the UK, the
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majority of these imports are intermediate inputs used for further production in Ireland. (Figure 8:
Effects of different UK withdrawal scenarios on Irish output)
In addition to disruption to trade flows, the UK's departure from the EU could affect the economy
through other channels. In the short-run, the ongoing uncertainty over nature of the UK's future
relationship with the EU after the transition period could cause firms to delay investment
spending. Heightened uncertainty could weigh on sentiment more generally, dampening
spending by households. Exchange rates and financial markets could also be affected. In the
long-run, the UK's departure is expected to have negative effects on the UK economy through
lower productivity and weaker investment. Slower UK growth arising from these effects will
reduce overall demand for Irish exports, although this could be mitigated by Irish exporters finding
new markets or by an increase in foreign investment and inward migration.
***
Market-based finance
I have spoken previously of the rise in non-bank finance and the risks therein. Ireland hosts a
large and internationally orientated market-based finance sector that has grown rapidly in recent
5
years. Irish-resident funds are the largest component of this sector in Ireland. (Figure 9:
Financial assets by institution type as a multiple of the country's GDP (GNI*) in 2017, selected
countries)
There are real benefits of market-based finance. It reduces reliance on the banking system,
which in Europe is relatively high. But, to realise those benefits, it is also important that
marketbased finance is resilient so that it can absorb, rather than amplify, shocks.
At the Central Bank of Ireland - like a number of other authorities internationally - we have
increased our monitoring of the risks of the sector, with a particular focus on vulnerabilities in
funds. Given these entities are international and cross-border in nature, we have also been an
active participant in international work on this issue. Key risks include liquidity mismatch and
excessive leverage in funds.
The onset of the COVID-19 saw a significant disruption in markets which raised questions
around the resilience of markets in the face of shocks. For example, the onset of the pandemic
saw large outflows from funds globally. Irish domiciled funds also experienced large outflows,
particularly those with exposures to less liquid assets or assets that became temporarily illiquid.
One of the fund segments that proved particularly susceptible to outflows in March was
corporate bond funds. The corporate bond market also saw a sharp deterioration in market
liquidity at the onset of the COVID-19 shock. Flows into corporate bond funds have stabilised
recently, as global central bank interventions have supported financial market functioning. But
looking ahead, a key risk for the corporate bond market stems from potential credit rating
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downgrades. We will continue to monitor the markets for such developments.
A second key area of vulnerability since the onset of COVID-19 was in money market funds. In
March, as the crisis began to unfold, some Irish resident money market funds - similar to money
market funds globally - experienced a substantial increase in redemptions. Irish resident money
market funds responded to this period of stress by increasing their liquidity positions and
reducing the maturity of their assets. This means that money market funds are better placed to
meet any future redemption pressures. But it also implies that money market funds have
increased their investment in short-term funding to the banking system and the real economy
and reduced their exposure in long-term funding. As money market funds play an important role
in the supply of credit to the real economy, we also need to continue to monitor these
developments.
Although the focus currently is on the near-term monitoring of risks and ensuring a coordinated
international response to the COVID-19 shock, the stresses experienced in March further
highlight the underlying structural issues relating to some segments of the funds sector. Risks
such as liquidity mismatch and leverage continue to be part of our focus. We are thinking hard
about how we can mitigate these risks.
Over the medium-term, one key area of focus needs to be developing and operationalising
macroprudential tools for market-based finance. In the case of the banking sector, we have seen
the benefits of building resilience in good times and allowing that resilience to be used when
shocks hit. We do not have an equivalent framework for market-based finance. Potential areas
of focus include the development of an internationally-consistent framework for the imposition of
ex-ante macroprudential leverage limits, and further work at an international level to ensure the
consistent availability and use of liquidity management tools across the EU (as previously
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highlighted by ESRB (2017) in their Recommendation on investment funds). More recently, and
in response to the COVID-19 shock, the ESRB (2020b) also emphasised the importance of the
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timely use of these liquidity management tools in responding to redemption pressures.
***
Conclusion
Thank you for listening. I'll stop there and take questions.
1
I would like to thank Thomas Conefrey, David Byrne, Stephen Byrne, Neill Killeen, Terry Quinn and Zivile Zekaite
for their contributions to my remarks.
2
European Commission, spring 2020 EC forecast; IMF World Economic Outlook, 6 April 2020; Consensus
Economics, 11 May 2020; ECB's Survey of Professional Forecasters (SPF) conducted between 31 March and 7
April.
3
See Conefrey and Walsh (2020) "Dealing with Friction: EU-UK Trade and the Irish Economy after
B r e x i t . "
www.centralbank.ie/docs/default-source/publications/quarterly-bulletins/quarterly-bulletin-signedarticles/dealing-with-friction-eu-uk-trade-and-the-irish-economy-after-brexit-(conefrey-and-walsh).pdf?sfvrsn=5
4
See Lawless (2018) "Intermediate Goods Inputs and the UK Content of Irish Goods
Exports." www.esri.ie/system/files/media/file-uploads/2018-06/BKMNEXT362.pdf
5
Cima, S., Killeen, N. and Madouros, V. (2019), "Mapping Market-Based Finance in Ireland", Central Bank of
Ireland Financial Stability Notes No 17, December.
6
See ESRB (2020a), "Issues note on liquidity in the corporate bond and commercial paper markets, the
procyclical impact of downgrades and implications for asset managers and insurers", ESRB Report, May.
7
See, ESRB (2017), "Recommendation of the European Systemic Risk Board of 7 December 2017 on liquidity
and leverage risks in investment funds (ESRB/2017/6)".
8
See, ESRB (2020b), "Use of liquidity management tools by investment funds with exposures to less liquid
assets", ESRB public communication, 13 May 2020.