The European economic policy response to a scenario of lower growth
and inflation
La Granda Summer Courses
Pablo Hernández de Cos
Governor

Distinguished rector, honourable mayor, academic authorities, dear students, ladies and
gentlemen. Let me begin by extending my particular thanks to Professor Velarde for his kind
invitation to participate in the closure of the 2019 La Granda summer courses.
It is an honour for me to be here in this building, whose doors are open to all those interested
in discussing and delving into the essential issues ever-present in these courses.
Today I would like to share some thoughts with you on the complex economic outlook the
European Union (EU) and, in particular, the countries comprising the euro area currently
face. This is at a time when free trade, the bedrock of the European project and an essential
source of the improvements in economic well-being in recent decades, is subject to
continuous threats.
I shall first describe the latest economic developments and the main challenges ahead. Then
I shall analyse what, in my opinion, the economic policy responses to these challenges
should be.
The return of protectionism
Only two years ago the global environment was a favourable one. It was marked by a
synchronised expansion of the emerging and advanced economies, reflected in the highly
robust world trade performance.
But the international economic setting turned more unfavourable in 2018. This situation has
run into 2019 to date, with a slowdown in growth (acutely so in manufacturing) and, in
particular, in trade.
Indeed, the latest information shows that economic activity is expected to have continued
worsening in recent months. This is evident in the manufacturing Purchasing Managers'
Index (PMI), which has since the start of the year stood below 50, a level indicative of a
contraction in activity. The reduction in the last few months in the global service sector PMI,
which had held firmer to date, in expansionary territory, suggests an increased risk of a
greater slowdown in global activity.
This downturn in activity has also been accompanied by more marked divergences across
geographical areas.
Among the advanced economies, activity has remained relatively robust in the United
States, underpinned by the fiscal expansion and the soundness of private demand.
However, the gradual tailing off of the effects on activity of tax cuts, the signs of a global
slowdown and the absence of clear inflationary signals have already prompted a shift in the
Federal Reserve's monetary policy. This has taken the form of the announced conclusion of
the balance sheet reduction process as from September and, last July, the first interest rate
cut since 2008. Moreover, the financial markets anticipate further cuts in rates in the rest of
2019 and in 2020.
In other geographical areas, GDP growth has been increasingly weak. This has been the
case in the European economy, to which I will refer later.
Among the emerging economies, China remains beset by the difficulties of managing in an
orderly fashion its much-needed economic rebalancing and deleveraging process, despite
the significant stimulus measures approved this year by its authorities. China is important
for the global economy: it accounts for almost one-fifth of global GDP, in purchasing power
parity terms, and it has contributed almost 1 percentage point to annual average global GDP
growth since 2005. And clearly, an additional slowdown in its growth rate would have major
global implications, through the trade and financial channels, and through the prices of
commodities, for many of which it is the main source of demand.1
Some of the emerging economies with the greatest vulnerabilities, such as Argentina and
Turkey, have been particularly affected by the financial tensions and continue to face
significant challenges. In Argentina especially the situation has worsened considerably in
recent weeks, against a backdrop of great political uncertainty.
As mentioned, the slowdown in activity has been particularly acute as regards trade. Various
factors are behind this downturn. They include most notably the impact of trade conflicts,
especially between the United States and China, and the uncertainty associated with Brexit.
The trade conflict has unfolded in various phases. In spring 2018, higher US tariffs on
different products (mainly imports from China) came into force, with the countries affected
retaliating accordingly. Moreover, the US government threatened to extend and step up
tariff rises (including, in particular, those on vehicle imports, a sizeable portion of the bilateral
trade with Europe).
The second half of 2018 saw some positive events: the signing by the United States, Mexico
and Canada of the pact replacing the North American Free Trade Agreement; the opening
of negotiations for a US/EU agreement; and the temporary truce called between the United
States and China to settle their differences.
More recently, however, in May and June this year, there was a fresh escalation in trade
tensions between China and the United States. US tariffs on $200 billion worth of Chinese
product imports were raised from 10% to 25%, and the response by the Chinese authorities
was to raise tariffs on US imports.
At the G20 summit in Osaka in late June, the two countries reached an agreement to
reinitiate trade negotiations. Yet despite this, and the fact that the United States
subsequently announced the suspension of certain restrictions on US companies selling
technological equipment to specific Chinese firms, August saw a new episode in the
escalation of tensions in the trade war between the two countries. Moreover, the United
States, which has accused the Chinese authorities of manipulating the exchange rate, has
postponed until November its decision on potential tariff increases on cars and their
components, a measure that would mainly harm the EU and Japan.
The economic literature fairly unanimously considers that trade openness in the world
economy in recent decades has been fundamental for global growth and social well-being.2
Against this background, the proliferation of protectionist measures is one of the greatest
threats to the world economy. Along with their direct repercussions on global activity, such
measures generate additional adverse effects through their impact on global confidence.
And these effects are so far proving significant. Accordingly, any future proliferation of
additional protectionist actions, further undermining confidence and affecting financial
conditions (and, therefore, business investment), might ultimately impact global GDP
severely.3
Turning to Brexit, it is over three years since the UK referendum on EU withdrawal. Doubts
persist over how the exit process will be resolved, and Brexit remains a primary source of
uncertainty for global economic activity and, especially, for the rest of the EU. After the latest
developments, including the new prime minister's decision to suspend parliament until
midOctober, the markets now consider a hard Brexit to be more likely.
On the simulations available, a Brexit with a trade agreement would have a relatively limited
effect. But the adverse consequences of a no-deal Brexit would be significant, especially
for the UK economy.4 Against this background of uncertainty, UK GDP has already posted
negative growth in the second quarter of this year.
The economic situation in the euro area: economic slowdown and low inflation
The more open European and East Asian economies have been those most affected by
these international trade developments. However, the adverse effects have spread to many
other economies through global value chains.
The euro area, in particular, has slowed significantly since early 2018. This is mainly due to
the strong easing in its exports. As a result, average GDP last year grew by 1.8%, 0.7 pp
down on 2017, and year-on-year growth in late 2018 and early 2019 fell to around 1%.
The euro area's high degree of openness (its trade flows with third countries account for
50% of the area's GDP, compared with 38% for China and 28% for the United States)
means it is particularly sensitive to external shocks and to the slowdown in world trade.
Moreover, the above-mentioned uncertainty over Brexit has prompted a contraction in
exports to the UK economy in recent years.
Also contributing to the slowdown in growth in the euro area have been specific
circumstances in certain sectors and countries. I refer in particular to the difficulties the
automobile industry is undergoing in adapting to the new environmental regulations, to new
production technologies and to protectionist threats.
Among the European countries, Germany's industry and export-based growth model has
been greatly affected by external developments. But Italy has been the most beleaguered,
given its weak GDP growth, the result of the uncertainty over the course of its economic
policy.
Indeed, the latest available information generally points to a slowdown in the growth rate
across the euro area, concentrated especially in the industrial sectors. Moreover, the
weakness of the external sector is also spreading to investment. That means the
sluggishness of external demand, heightened political uncertainty in some countries and the
easing in corporate profits are already bearing down on firms' spending plans. Furthermore,
the leading indicators of euro area exports show no signs of having touched bottom.
The flash estimate for euro area GDP in the second quarter shows quarter-on-quarter
growth of 0.2% (compared with 0.4% in the first quarter), with negative growth of 0.1% in
Germany and stagnation in Italy. Some countries, such as France and Spain, which have
remained more buoyant in this period, have also posted slowdowns - to 0.3% and 0.5%,
5
respectively - in the second quarter of the year.
In contrast, the most favourable factor since the onset of the economic recovery in the euro
area has been the improvement in the labour market. This has been at the root of household
income growth. During the current upturn, employment has responded forcefully to GDP
growth. The unemployment rate currently stands at 7.5% of the labour force, very close to
the historical low seen in the pre-crisis years.
Strong job creation has contributed to reducing labour market slack. This has begun to be
mirrored in wage growth and in an increase in labour income, which has enabled
consumption to play a key role in euro area growth. That said, labour continues to be
underutilised in some economies in the area.
Yet in the euro area as a whole, the rise in wages and in unit labour costs has not fed through
to prices, which has prompted a contraction in business mark-ups. In fact, the globally
prevalent moderate inflation and growing competitive pressures, along with the increased
uncertainty over future euro area exports, would account for firms' heightened caution when
passing through labour cost increases to the prices of their products.
The upshot is that, excepting the oscillations associated with more volatile items such as
energy or certain services (e.g. tourist packages), the various measures of core inflation are
holding at very moderate levels of around 1%, far removed from the monetary policy
reference. Indeed, since 2013 euro area inflation has averaged 0.9%, practically half that
observed during the first 10 years of EMU (2.1%).
In parallel, the financial markets-based indicators of long-term inflation expectations have
fallen forcefully since late last year and are holding at very low levels. That broadly coincides
with the signals captured in opinion-based surveys. These indicators are habitually used to
ascertain how anchored inflation expectations are with respect to the ECB's medium-term
objective (inflation rate at below, but close to, 2%). True, most of the reduction in inflation
expectations according to the market indicators appears to be due to the decline in the
inflation risk premium. But the level of this premium is in negative territory, indicating that
agents would appear to be hedging against the risk of very low or even negative inflation
rates.
As regards the medium-term outlook, the latest ECB survey of professional forecasters
showed an average forecast of annual HICP-based inflation of 1.3%, 1.4% and 1.5% for
2019, 2020 and 2021, respectively, marking a downward revision of 0.1 pp for each year
compared with the previous forecast. For 2021 it is even below the Eurosystem's June
projection, which placed it at 1.6%.
There is also evidence that euro area economic agents are setting greater store by recently
observed inflation when determining their inflation expectations and, therefore, their price
and wage-setting decisions. The persistence in recent years of very moderate inflation rates
might be behind this.6
In this setting, the risks to the euro area growth outlook remain clearly tilted to the downside.
They reflect the prolonged presence of protectionist tensions; the uncertainty associated
with geopolitical factors (such as Brexit and the political uncertainty in Italy); the doubts over
the intensity of the ongoing slowdown in China and the possible repercussions for the global
economy as a whole; and the vulnerabilities that some emerging economies, such as Turkey
and Argentina, continue to evidence.
There are also some structural factors suggesting that a setting of low growth, modest
inflation and, consequently, low interest rates might prevail over time.
Among the main determinants is population ageing. This is a common trend in the advanced
economies whose consequences go far beyond public finances and health systems. Ageing
alters economic agents' patterns of saving, investment and labour supply, and affects the
potential growth of economies by reducing the working-age population and its productivity,
among other factors.
The other major challenge the European economies must face is the lower rate of
productivity growth. This is admittedly common to other advanced economies, and is in
contrast to the technological progress of recent decades. But we cannot ignore the fact that
productivity growth in Europe is far lower than that observed in the United States. In some
countries, such as Italy, productivity per employee has even stagnated in the past two
decades.
Low inflation is a common trait of other advanced economies and a fundamental challenge
for most central banks. It therefore continues at present to be one of the central matters for
discussion in the academic arena and on the monetary policy boards of the Eurosystem,
the Federal Reserve and other central banks.
In its latest Annual Report, the Banco de España dedicated special attention to these
matters. The report highlights the considerable uncertainty over the factors that may be
checking the rise in inflation at the global level. They include most notably structural
phenomena, such as population ageing, globalisation, the expansion of value chains and
the attendant increase in competition, along with swift technological progress and the
emergence of new forms of marketing and major sales platforms. Moreover, at certain times
more transitory factors may have played a part, such as low oil prices and the considerable
slack in some labour markets further to strong job destruction during the crisis.
The monetary policy response to an extended scenario of slow growth and moderate
inflation
The complexity this setting poses for economic policies in Europe is most considerable. I
shall refer first to monetary policy.
The context of low inflation and slow growth has given rise to a broad consensus on the
ECB Governing Council. This is namely the need to maintain a significant monetary policy
stimulus that can help anchor the economic expansion and ensure that inflation is on a
sustained path towards the medium-term reference.
Since the end of the asset purchase programme (last December), the main tool for
maintaining the monetary stimulus and anchoring agents' expectations has been interest
rate policy and forward guidance. In June 2018, then, it was determined that policy interest
rates would hold at current levels until, at least, the summer of 2019 and, in any event, until
inflation should converge in a sustained manner towards levels compatible with price
stability. That is to say, our forward guidance has twin strands: the first is linked to a specific
date until which the Governing Council commits not to raising interest rates; and the second
makes these increases conditional upon convergence towards our medium-term inflation
aim.
Forward guidance has also been strengthened by the maintenance of the policy to reinvest
the principal payments from maturing securities purchased under the asset purchase
programme for an extended period of time past the date when the Council starts raising the
key ECB interest rates.
However, in light of the weakness of the macroeconomic figures, the decline in inflation
expectations and the conjunction of numerous sources of risk, communication by the ECB
Governing Council has progressively been adjusted towards a more accommodative
monetary policy.
Specifically, at its July meeting, the Council added further accommodative bias in its
communication on policy interest rates. It signalled that it expects rates to remain at their
present or lower levels at least through the first half of 2020, and in any case for as long as
necessary to ensure the continued sustained convergence of inflation to its aim over the
medium term.
The Governing Council also acknowledged that inflation rates, both realised and projected,
have been persistently below levels that are in line with its aim. That is to say, the actual and
projected inflation levels I have referred to cannot be considered to be compatible with the
ECB's mandate.
It further stressed that, if the medium-term inflation outlook continues to fall short of its aim,
the Governing Council is determined to act, in line with its commitment to symmetry in the
inflation aim.7
The notion of symmetry here means that the ECB can tolerate both upward and downward
deviations in relation to our inflation aim of "below, but close to, 2%", provided it is foreseen
that inflation will converge on our medium-term objective. It also means that the figure of
2% is a reference for average medium-term inflation, but it is not a cap that prevents prices
from temporarily increasing at rates of over 2%. Moreover, the concept of symmetry reveals
that the Governing Council is committed to acting resolutely both whether inflation is
persistently above or whether it is below 2%. It may also be inferred from this symmetry
that, since inflation has been below-target in recent years, fulfilment of the aim in the
medium term may require it to be above the aim at some time in the future.
Consequently, the ECB Governing Council has announced that it stands ready to adjust all
of its instruments, as appropriate, to ensure that inflation moves towards its aim in a
sustained manner. Against this background, we have tasked the relevant Eurosystem
Committees with examining options, including ways to reinforce our forward guidance on
policy rates and options for the size and composition of potential new net asset purchases.
There is a possibility that durably low or even negative interest rates may have effects on
financial stability and bank profitability. It is true that Eurosystem estimates suggest that so
far the positive effects, in terms of greater economic activity and improved credit quality,
offset the adverse effects on banks' net income. But it is necessary to monitor this matter
continuously in order to determine whether measures are needed to mitigate the adverse
effects of low rates on the banking system's intermediation capacity. The Governing Council
has thus also requested that the Eurosystem's technical committees analyse a potential
tiered system for reserve remuneration.
It should be recalled that, in March, new quarterly longer-term financing operations were
announced. These will begin to be implemented in September, under very favourable
financing conditions, with the aim of maintaining the current low costs of bank funding and,
therefore, of overall borrowing by households and firms.
It is perhaps worth reiterating here that the ECB's monetary policy has had very positive
effects on euro area activity and inflation.
In fact, by easing financial conditions and reducing financial market fragmentation, the
ECB's expansionary monetary policy has substantially contributed to the improvement in
the euro area economy. At the same time, it has prevented the period of negative inflation
rates experienced by the European economies further to the crisis-induced recession from
turning into a deflationary spiral.
Specifically, according to some ECB papers8 and to in-house Banco de España estimates,
it is believed the set of monetary policy measures adopted since mid-2014 will have an
overall impact on the euro area's real GDP growth and inflation. In both instances this is
expected to be cumulatively of the order of around 2 pp between 2016 and 2020.
It should also be underscored that these effects have arisen from the combination of the
various instruments used. Beyond their individual impact, these instruments mutually
complement and reinforce one another. Hence, the joint application of short-term interest
rate cuts, asset purchases, special financing operations aimed at banks and an active
communication policy of the part of the ECB Governing Council have all allowed the yield
curve to ease in recent years. This has had a most notable impact on financing conditions
for all agents, public and private alike, within the area.9
It is important this complementarity be maintained with the new measures, should they
prove necessary, in order to maximise their effectiveness.
Indeed, following the adjustments recently made to the ECB Governing Council's
communication, market interest rates in all segments have continued to decline, and the
yield on the GDP-weighted euro area 10-year sovereign bond has fallen to below 0.2%. The
sovereign bond risk premia relative to the German benchmark and the yield spreads on
corporate bonds have also declined.
Notwithstanding the monetary policy decisions that may have to be adopted in the short
term, I believe this setting also calls for some thoughts on the medium-term monetary policy
strategy.
It should be borne in mind that, insofar as interest rates hold at levels close to their effective
lower bound for a longer period, central banks will have less headroom to cut rates in
response to future crises. They also have to resort more frequently to less conventional
measures to increase their balance sheets.
This situation has led some central banks to discuss possible alternatives to the current
monetary policy strategy, aimed at countering the constraint of the effective lower bound of
interest rates. The US Federal Reserve has been most prominent in this connection,
conducting a far-reaching review of its operational framework.
In this connection, I am of the opinion that the ECB should launch a similar exercise. Among
other factors, it should reflect on a clarification of our quantitative price stability objective,
in order to align it with the specific definitions of other developed countries' central banks
and provide for better communication and anchoring of agents' expectations.10 The latest
Annual Report of the Banco de España, to which I referred earlier, analyses the most
favourable and least favourable aspects of several possible strategic options in this area.
The contribution of non-monetary economic policies is pivotal
That said, the participation of non-monetary economic policies is essential for shoring up
the recovery, entrenching higher growth rates and, thereby, smoothing convergence by
inflation towards its medium-term reference.
The need to create a fiscal stabilisation instrument in the euro area
Recent experience has highlighted the difficulty of achieving a more appropriate
macroeconomic policy mix for the euro area as a whole under the current framework of rules
and institutions in which European fiscal policy operates.
In the euro area each country decides its fiscal policy. Monetary policy, meanwhile, is
designed taking into consideration the situation of the euro area as a whole. Attaining an
appropriate mix of both would require effective coordination mechanisms or the creation of
a fiscal stabilisation capacity for the entire area.
As regards fiscal coordination mechanisms (based on the Stability and Growth Pact), there
is consensus on the need for a far-reaching review.11 SGP arrangements have become
excessively complex over time, which hampers transparency in their application, their
implementation and, ultimately, their fulfilment. The most evident consequence of this is,
across the board, that fiscal policy design has been procyclical in numerous countries and
in the euro area as a whole.
In recent years, some countries running expansionary public finances are those whose high
debt and structural deficits would have advised a fiscal consolidation drive. The
restructuring of public finances in these countries is a priority if it is wished to count fully on
fiscal policy as a national macroeconomic stabilisation instrument ahead of any potentially
more adverse scenario.
In such a scenario, those countries with more fiscal space might provide a greater budgetary
stimulus to their economies, especially bearing in mind that they have been particularly
affected by the recent slowdown as a result of their heavy exposure to international trade
flows. In the current setting of very low interest rates, the positive impact of the fiscal
expansion would not only be greater in the countries pursuing it; it would also spread to the
other partners, giving rise to positive spillover effects for the area as a whole. Yet as I have
indicated, in the current euro area fiscal framework these decisions are the responsibility of
national governments, which hampers their adoption.
The composition of spending is also important. In particular, the growth of public investment
continues to be very moderate, following the cuts to it during the crisis. This is set against
the major challenges we must face in the coming years in various areas, such as digital
transformation, the energy transition, population ageing and, generally, the necessary
adaptation of our productive system to a more complex and demanding global environment.
In light of this, it is a great concern that the euro area should still not have fiscal policy tools
capable of contributing to a common response to these challenges and promoting a greater
degree of cyclical stability for the Union as a whole. Indeed, recent Banco de España
studies12 point out that while in the United States the federal budget smooths economic
shocks by close to 10%, in Europe this mechanism is non-existent.
The recently created instrument for convergence and competitiveness, while a step in the
right direction, lacks stabilisation capacity. It does not incorporate some of the potentially
most effective elements, such as European unemployment insurance and the use of
European funds to mitigate the impact of specific shocks on certain economies.
The lack of effective macroeconomic policy coordination mechanisms in the euro area is
exacerbated when monetary policy comes up against its effective interest rate limits. As I
said earlier, this circumstance might become more frequent in the future if we move into a
more persistent setting of low rates. Moreover, it is in this setting that the effectiveness of
fiscal policy may prove greater.13
There is thus a pressing need to create some type of common cyclical insurance mechanism
in the euro area. This instrument would help automatically absorb adverse shocks at the
aggregate level (symmetric) or idiosyncratic shocks in certain countries (asymmetric). Its
dual aim would be to smooth effects in individual countries and safeguard the stability of
the euro area as a whole.
Some recent analyses suggest that it would be possible to design a mechanism which,
without committing major funds (fewer than the current European budget) and without it
entailing permanent cross-State transfers, would provide for a similar stabilisation capacity
to that achieved with the US transfer system.14
The role of macroprudential policy
We should not forget the role that so-called "macroprudential policy" can and should play.
The introduction of macroprudential instruments to complement the stabilising capacity of
monetary and fiscal policies is probably one of the most significant advances in the wake of
the international financial crisis.
For the countries belonging to a monetary union, the introduction of these tools is
particularly important. This is because it is one of the few instruments available nationally to
ensure the stability of the domestic financial system.
In my opinion, macroprudential policy has a dual role to play in the current setting.
First, continuing low or even negative interest rates over an extended period may have
adverse effects on financial stability. Macroprudential policy should be primarily entrusted
with reacting if some of these risks emerge, actively combating potential excessive debt
growth and protecting financial institutions against the hypothetical materialisation of these
risks. This policy action should affect both the banking sector and the non-bank financial
sector, depending on where the signs of exuberance are perceived.
Second, some macroprudential instruments, such as the countercyclical capital buffer
(CCyB), can be used to build up capital buffers at financial institutions in times of plenty that
can be deployed when conditions worsen. The use of macroeconomic stabilisation
mechanisms, such as the CCyB, is particularly significant in a setting, such as the present
one, in which monetary policy scope is more limited.15
Structural reforms conducive to raising potential growth must be undertaken
It is also imperative to address the structural shortcomings hampering productivity and the
generation and harnessing of investment opportunities in the euro area. At the same time,
measures should be introduced geared to making all citizens party to the benefits the
European Project entails.
These structural reforms, insofar as they are expansionary supply-side policies, are
especially appropriate in the international setting I have described, in which the main growth
shocks and risks (such as protectionist tensions and the uncertainty surrounding Brexit)
place constraints on the global supply of goods and services, competition and productivity
and harm the production capacity of the economies affected through the negative effects
of uncertainty on business investment.
In addition, and as regards the need discussed above for fiscal policy to provide a
macroeconomic stimulus where there is space for this, recent economic literature suggests
that there is considerable potential for positive synergies between structural reforms and
demand-side expansionary policies. In other words, the same structural reforms may
provide a greater boost to economic activity if they are implemented in parallel with
expansionary monetary and fiscal policies.16
In this setting, the slow progress made by the euro area member countries in implementing
the European Commission's structural reform recommendations in the 2019 European
Semester is worrying. Reform headway is particularly slow as regards the elimination of
obstacles in the provision of professional services and in the network industries, and
improving the business environment by reducing the administrative burdens that hinder new
start-ups.
Greater efforts should be a priority in at least two areas. First, we must improve human
capital and active employment policies to promote the rapid reallocation of workers towards
the growth industries. Second, public and private spending on innovation must increase to
create new business opportunities. Europe cannot stand on the sidelines as new
technologies are developed and as the United States and China battle for technological
supremacy.
In the financial arena, for example, most of the most successful technology companies are
headquartered in the United States or in Asian countries.
The increase in public investment should focus on improving transport and communication
infrastructures to maintain connectivity with business centres and to promote the
development of European value chains and, thereby, regional cohesion.
Moreover, we should not forget the impact that all the latest technologic