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Published: 26 October 2024

Partly cloudy skies in the euro area, with a silver lining
Speech Klaas Knot at the G30 International Banking Seminar
Washington, 26 October 2024

Good morning everyone,

It is my pleasure to present the euro area perspective in this panel session on the Global
Economic Outlook. The latest PMI releases point to steady global growth. Weakness in
manufacturing is compensated by strong growth in the service sector.

Economic growth has been sluggish for two years

EA economic outlook is less favourable «- Driven by sluggish domestic demand
compared to global economies... (a.o. low investment and consumption)
Composite PMIs GDP-growth and contributions euro area in Percent qo-q
60 3,0

38 20

DNB Qg AL

However, as you can see in the left hand chart, the economic situation in the euro area is
less favorable than the global average. The current mood is a bit like October weather in

Amsterdam. Not as bad as some people would have you believe, but definitely not great

either.

Economic growth in the euro area has been sluggish for two years now. As shown in the
right hand chart, especially domestic demand has been weak. Initially, this could be
explained by falling real wages. Over the past two years, however, wages have largely been
catching up with prices. The short-term outlook is pointing to slow growth while economic
sentiment remains subdued and the household savings rate is still higher than before the
pandemic. Looking further ahead though, we do expect the economy to strengthen. Rising
real incomes will allow households to consume more and the gradually fading effects of
restrictive monetary policy will support consumption and investment.

Zooming in on the various member states, confidence is not low everywhere. Economic
sentiment is significantly above the long-term average in for instance Spain, Portugal and
Greece. The mood is especially good in the service sector, benefiting from the reallocation
of consumption from goods to services after the pandemic. This growth boost is
particularly visible in tourism and hospitality. But also other sectors of the economy
perform relatively well in these countries.

Other countries are lagging behind. This is mainly the case for Germany, where a
combination of factors is weighing on the traditionally strong manufacturing sector.
Energy-intensive manufacturing firms are still suffering from elevated energy prices.

Moreover, the sector is faced with weak external demand while domestic demand is not
growing due to weak private consumption and falling business investment.

To me, the weak domestic growth in the euro area is slightly puzzling. Maybe the past high
inflation or the political polarization and geopolitical tensions is weighing on consumers'
moods. On the policy side, fiscal uncertainty may add to this picture and a significant fiscal
consolidation in, for instance, France is necessary to bring public finances back on track and
reduce this uncertainty. In line with the revised fiscal framework, the fiscal stance in the
euro area is expected to tighten this year, and coming years, as energy and inflation

support measures are gradually phased out. Debt levels, however, are expected to increase,
particularly in high-debt countries.

This said, I'm by nature an optimist. So let me get to the silver lining. While macro
indicators point to a soft landing, we do not foresee a recession in the euro area. Also, the
financial sector is resilient and inflation is getting close to target.

Let me focus on inflation.

Disinflation proceeds, but services inflation still high

Disinflation in the euro area is well on ... But wages keep domestic inflation
track... elevated
HICP euro area, percentcontributions by component GDP deflator EA, percentcontributions by component

10,0
3,0
6,0
4,0

2,0 j i woe-nnW.
0,0

-2,0
-4,0
-6,0
-8,0

10

6

4

23 24 25 20 21 22 23 24 25 26
mm Services sme Hon-energy IG me Unt tax mae Unk profits
Food ak & tobacco ume Energy me Labour productivity me Wages:
O DNB SINK? total --Core inflation --GOP, defistor (Eurostat) e ULC

Headline inflation in the euro area has come down to around 2%. The latest reading was
1.7% for September, confirming our assessment that the disinflationary process is well on
track. Underlying there are differences between components. On one end, energy prices
have pushed down the latest inflation reading, contributing -0.6 percentage points to

headline inflation in September. And on the other end, services inflation remains stubbornly
close to 4%.

Part of this strong services inflation is driven by growth in nominal wages, which are still
catching up with past inflation. We expect these second round effects to dampen further in
the course of next year. The GDP-deflator, a measure of domestic inflationary pressures,
has come down to 3.0% in the second quarter, from above 6% one year earlier. As you can

see on the right, while unit profits were the largest contributors in the high inflation
quarters, increasing unit labor costs are now driving the GDP-deflator. And in absence of
labor productivity growth, it is wages that determine most of domestic inflation.

On inflation, it is clear that the risks surrounding the outlook have become more balanced.
In the short term, given the downward surprise of both headline and core inflation in Q3 of
this year, we may see inflation dropping faster than expected. This is also supported by the
further declining monthly dynamics of inflation and declining goods price pressures.

Risks to inflation have become more balanced

Market-based inflation measures more +. implying that markets view risks to
centered around 2% target... inflation as balanced

2022 2023 2024

<0 #0-1% #1-1.5% #1.5-2% *
#2-2.5% =2.5-3% =3-4% >4% -- Balance of risks (2 years ahead)

figure 5 (US), 6 (RMS) show the option-imolied inflation Gistribution for 2-years ahead. Figure 6 shows a balance of risks metric
¢ based on options-implied inflaton probetslities. The balance of risk is defined as the difference between the probabilities assigned
© DNB to inflation outcomes above vs below the 2% target level. Hence, the balance of risk indicator condenses the information content 4
~ Of the whole options-impiied distribution into one metric and shows the market view on the directional risks to price stability,

These charts underline that also market participants hold a balanced view regarding the
risks to inflation. As you can see in this option-implied distribution of inflation, the
likelihood of inflation either below or above our target has become even-handed. This
implies that for the coming two years market-based inflation expectations are much more
centered around the ECB's 2% symmetric inflation target.

Coming from a prolonged period of setbacks and too high inflation, this is good news. Yet,
at the same time, it is still too soon to declare victory, as in the medium term upward risks
remain. We still need a significant easing of wages - which is only expected in the course of
2025 - and relatedly, a cooling off of services inflation to durably return to 2% over all. On
top of that, uncertainty remains significant, in particular on the supply side of the economy
as we are residing in an environment of heightened geopolitical risks. Hence more adverse
supply shocks hitting the euro area economy can pose renewed upside deviations from our
inflation target.

Based on this assessment, the Governing Council has taken another step in removing the
top level of policy restriction at its October meeting. Incoming data since the September
meeting have strengthened our confidence that inflation will return to target in a timely
manner. Also, the data point to increasing risk of disappointing growth in the near and
medium term. Given that policy rates are still some distance away from the range of

neutral rates, the decision to lower the deposit facility rate by 25 basis points is robust
across a wide range of scenarios. Looking forward, in this environment with significant
uncertainty about the supply side of the economy, it is important keep all options open.

Retaining full optionality would act as a hedge against the materialisation of risks in either
direction to the growth and inflation outlook. On the one hand, policy restriction may
reduced quickly if incoming data indicate a sustained acceleration in the speed of
disinflation or a material shortfall in the economic recovery with its associated implications
for the medium term inflation outlook. On the other hand, policy restriction may be taken
away more slowly should upside risks to inflation materialise or if incoming data sheds the
opposite picture regarding growth and inflation. In any case, the meeting-by-meeting and
data-dependent approach has served us well, as it helped to maintain the much-needed
two-way optionality and flexibility for future rate decisions.

On that rather positive note, let me stop here and give the floor back to you, Mark.

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