Peter Praet: Economic recovery in the euro area - the role of monetary
policy
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the Belgian Financial Forum, University of Antwerp, Antwerp, 13 December 2013.
* * *
I would like to thank Federic Holm-Hadulla for his contribution to the preparation of this speech.
Ladies and Gentlemen,
It is a great pleasure to speak to you at today's event.
I would like to use this opportunity to share my assessment of where we stand in terms of
economic and monetary developments in the euro area.
I will start with the economic situation we currently face and give you my take on the future
outlook, also on the basis of latest Eurosystem staff macroeconomic projections, which - as
you know - play an important role in informing our economic analysis on a quarterly basis.
We are moving on a trajectory of modest growth, gradually recovering from the economic
downturn of the past years. Still headwinds persist and I elaborate in a minute on the most
important headwinds that we currently seeing.
I will also discuss the signals coming from our monetary analysis, which assesses money
and credit developments to identify risks to price stability over a medium- and long-term
horizon. Here, particularly the credit side presents itself as still sluggish, thus pointing to
subdued price developments in the medium term future.
Finally, I will draw together the complementary bits and pieces of our analysis to explain our
current monetary policy orientation, which is characterised by two features: first, that we
expect our key interest rates to remain at present or lower levels for an extended period of
time; and, second, that we stand ready to adopt additional accommodative monetary policy
measures, if and when necessary to safeguard price stability.
Our latest economic analysis
Let me start by briefly summarising how we see the euro area economy evolving, including
an assessment of the latest Eurosystem staff projections.
The recovery continues to proceed at a modest and uneven pace across the euro area. In
fact, real GDP is projected to pick up from the fourth quarter of this year onwards, and the
recovery is expected to accelerate slightly by the end of next year.
In the euro area as a whole, real GDP is projected to still contract this year by 0.4%, but then
to increase by 1.1% in 2014 and 1.5% in 2015.
According to our staff's projections, the sustained increase in activity would be mainly driven
by a gradual recovery in domestic and external demand, with the pickup in domestic demand
being supported by several factors:
First, reduced uncertainty is expected to gradually feed through to the real economy.
Second, our accommodative monetary policy stance will continue to support the recovery, by
providing for: low monetary policy interest rates; extensive funding reassurance to euro area
banks, inter alia, by offering liquidity via the fixed rate full allotment mode at least until
mid2015; and a lasting positive impact of forward guidance on money market conditions.
Third, the euro area economy will encounter less fiscal drag as countries have made
important progress in improving their budgetary positions.
Fourth, real disposable incomes are expected to benefit from a drop in commodity prices.
And, finally, starting from 2014, the recovery is also expected to benefit from fading credit
supply constraints.
Still, the key question to ask is why are we not moving faster out of the crisis?
The recovery continues to face headwinds, especially in stressed countries and a number of
factors may hinder a faster recovery.
First, notwithstanding some progress in rebalancing, in many euro area countries we will still
see further adjustment of private and public sector balance sheets. Don't forget in this
context that past recoveries have been driven by a pick-up in housing and construction
activity that then continued to feed its way through to overall economy. Now, with a lot of
household wealth lost in this crisis and with the balance sheets of the private and public
sectors still retrenching, this traditional source for recovery seems to be hampered and less
desirable, calling for more structural and balanced growth models.
Second, and closely related, investment has been declining over the past year and will most
likely only gradually pick-up, starting from levels far below pre-crisis averages. Of course,
anaemic demand conditions, corporate balance sheet restructuring and high lending rates
particularly for SMEs are in several countries weighing on investment.
And third, labour market conditions do not provide much comfort. Unemployment is expected
to remain high and persistent. Considering also the somewhat less favourable outlook in
labour intensive sectors and the growing structural component in the current unemployment
figures we may see sluggish labour market conditions for some time in the future, despite
decreasing labour cost conditions.
Overall, a significant amount of slack in the economy will persist until the end of the
projection horizon. Moreover, the balance of risks around the projected real GDP growth
outlook is to the downside in 2014 and 2015. This reflects mainly three risk factors,
comprising: potentially higher oil prices, lower euro area foreign demand and additional fiscal
consolidation efforts, in particular in 2015.
So what does all this imply for price developments?
In keeping with the weak economic dynamics, we continue to expect subdued inflation
extending into the medium-term.
According to our staff projections, euro area HICP inflation is projected to edge slightly
upwards from 0.9% in the fourth quarter of 2013 to 1.2-1.3% over the rest of the projection
horizon. In yearly averages, HICP inflation is projected to reach 1.4% in 2013, 1.1% in 2014
and 1.3% in 2015.
When interpreting the subdued inflation profile, it is also important to consider its main
drivers. For example, if we are merely observing a one-off decline in more volatile
components of HICP inflation, this is less of a policy concern than if low inflation reflects the
interplay of more durable economic factors, thus showing up also in less volatile
components.
However, decomposing euro area inflation over the last two years into more or less volatile
components does not yield a clear-cut picture in this regard.
On the one hand, we see that energy and food prices (both of which tend to be relatively
volatile) play a major role - accounting for about 80% of the 2.1 percentage point decline in
HICP inflation over that period.
On the other hand, we also observe a decline in the contributions from non-energy industrial
goods and most notably services prices - both of which are more closely related to
fundamental factors.
Also, low inflation can be an outcome of policy measures. A case in point is Germany, where
inflation has remained relatively low, despite a robust recovery from the crisis.
But wage developments have been moderate in Germany, with compensation per employee
growing by just 1.8% year on year in reflection of structural reforms that have been
undertaken in the past. And, Germany compared with other euro area countries has
recorded a relatively low contribution from higher indirect taxes and administrative prices to
inflation.
At the euro area level, our staff sees the risks to the projected HICP inflation outlook slightly
on the upside towards the end of the projection horizon. This is because upside risks from
higher oil prices, a depreciation of the euro and higher indirect taxes are only partly offset by
downside risks stemming from lower foreign and domestic demand.
Overall, the staff projections are in line with our assessment of subdued underlying price and
cost pressures that suggest a period of prolonged low inflation.
Indeed, pipeline price pressure pressures appear low with producer prices having declined
for a while, recently declining even further to -1.4% in October from -0.9% in September.
Also labour cost pressures are very much contained, particularly in the presence of moderate
wage growth, high unemployment and ample spare capacity.
External price pressures eased during the first three quarters of 2013, i.a. owing to sluggish
global demand and declines in oil and non-oil commodity prices. The import deflator is thus
estimated to have declined in year-on-year terms over this period. While it will continue to fall
in the following quarters as a result of these factors, the import deflator is expected to
increase slightly from mid-2014 onwards, as the downward impact of the previous
appreciation of the euro fades away, as non-energy commodity prices increase and as
import demand gains momentum, allowing for stronger mark-ups.
On that basis, also our recent assessment from the December Governing Council meeting is
fully consistent with what we have been saying now for some time: inflation is low and we do
not expect this to change for some time.
Signals from the monetary pillar
Let me now turn to the signals we have received from the monetary pillar.
In a nutshell, these signals confirm the subdued medium-term inflation outlook deriving from
the economic analysis.
While monetary dynamics have been weak, essentially since the onset of the crisis, growth in
broad money moderated further in recent months.
The annual growth rate of the broad monetary aggregate M3 decreased to 1.4% in October
2013 (or 1.7 % adjusting for one-off effects), which is the latest available data point, from
2.0% in September 2013. This marks a continuation in the deceleration from previous
months. After M3 still grew at 2.8% in the second quarter of 2013, the third quarter recorded
a significant drop in this growth rate to 2.2%.
A key driver of these recent developments in M3 is that, in the current environment,
monetary assets only yield little remuneration. As a consequence, money holders are
incentivised to engage in two types of substitution:
Either they hold very liquid instruments, such as overnight deposits. This shows up in still
robust growth in the narrow monetary aggregate M1, which stood at 6.6% in October 2013,
slightly down from 6.7% in September.
Or they diversify away from short-term deposits and marketable instruments towards better
remunerated - but riskier and less liquid - instruments. To the extent these instruments are
outside M3, this dampens the growth in the broader monetary aggregate.
On a positive note, we are observing some strong net inflows of capital from outside the euro
area that support monetary dynamics. Since these inflows are directed at both, stressed and
non-stressed euro area countries, they help mitigate financial fragmentation.
At the same time, it remains important to reinvigorate sources of money creation also from
inside the euro area as the recovery takes hold.
In this context, we have to acknowledge that the provision of credit to the real economy
continued to contract, even if the pace of that contraction has levelled off recently.
The annual growth rate of loans to households stood at 0.3% in October, broadly unchanged
since the turn of the year.1
At the same time, the annual rate of change of loans to non-financial corporations was -2.9%
in October, compared with -2.8% in September. But on the other for larger firms other
sources of financing have been more available.
These weak loan dynamics for non-financial corporations continue to reflect primarily their
lagged relationship with the business cycle, the overall heightened credit risk and the
ongoing deleveraging and overall adjustment of financial and non-financial sector balance
sheets, also related to past excesses.
The ECB's comprehensive balance sheet assessment, including Asset Quality Review and
Stress Test, should lead to greater clarity on the state of the banking sector. Combined with
appropriate resolution strategies and backstops, this will strengthen banks' balance sheets
and ultimately improve the prospects for bank lending in the future.
Implications for monetary policy
How should monetary policy act in these conditions?
Assessed against our price stability objective, the subdued inflation outlook, on the back of
weak economic and monetary dynamics, clearly warrants an accommodative stance.
It is against this background that we lowered rates in November. And it is against this
background that we expect our key interest rates to remain at present or lower levels for an
extended period of time.
Taking stock of the effects that our recent policy measures have had on economic and
financial conditions, we see positive signs emerging.
The November rate cut has been followed by a pronounced and persistent easing in
monetary conditions in the euro area - as manifest for instance in a downward shift in term
money market interest rates and other important market interest rates.
Moreover, our forward guidance continued to effectively support our policy intentions: first, it
has mitigated the sensitivity of the money market term structure to surprises from economic
data releases; and second it has reduced market uncertainty about the path of future short
term rates.
But notwithstanding this favourable track record of our recent policy measures, we should
remain alert to any contingencies that may give rise to downside risks to price stability.
In particular, we are closely monitoring money market conditions and their potential impact
on our monetary policy stance. By extending the horizon of the fixed rate full allotment mode
at least until mid-2015 we have provided additional funding reassurance that will support the
transmission of monetary policy signals through the banking system.
At the same time, we stand ready to adopt additional measures if we were to observe
developments in money market conditions that threaten to interfere with our policy intentions.
Moreover, the subdued inflation outlook provides little safety margin against further adverse
shocks that may give rise to downside risks to price stability.
That safety margin is reflected in our focal point of inflation rates just below 2% in the context
of our price stability. It ensures that steady state inflation provides for a sufficient buffer away
from zero.
With an inflation outlook below this focal point, our reaction time for additional
accommodative policy action shortens accordingly.
In this regard, the debate among observers has focused on the question, which measures
the ECB were to take under these circumstances.
As explained - and demonstrated - in the past, the ECB is in a position to adopt a wide
range of instruments to ensure price stability, in line with the extensive instrument
independence it has been granted under the Treaties.
This allows us to tailor our policy response to the specific contingencies that the euro area
may face at a given point in time.
We will continuously evaluate our policy options and we will act if the circumstances so
warrant and adopt measures that are most effective in confronting the challenges at hand.
But we need to be also wary of the limitations of further measures. Let's not forget that our
monetary policy stance is already accommodative and financing conditions are favourable
overall.
Indeed, we see sluggish demand for credit despite low lending rates. We see muted
investment, despite firms building up cash reserves. This cannot be solved by further
accommodation, but is a clear cut case for the right structural policies.
In fact, with structural economic policies directed towards more competitiveness, sustainable
fiscal budgets and financial sector policies and governance that set the stage for sound
banks' balance sheet and more stable financial market conditions, economic confidence and
confidence in the euro area as an economic and financial centre will return and unleash the
willingness for more credit provision, more investment and domestic demand.
Conclusion
With this, let me conclude.
The euro area economy continues to recover, albeit at a slow and uneven pace. Reflecting
the weak economic and monetary dynamics, underlying price pressures in the euro area are
expected to remain subdued over the medium term.
The ECB's monetary policy has successfully contributed to this outlook. Our stance is
accommodative in full consistency with our prime task to maintain price stability in the euro
area. This is vindicated by the consistent anchoring of inflation expectations for the euro area
over the medium to long term in line with our aim of maintaining inflation rates below, but
close to, 2%. Yet, there is no doubt that the outlook on inflation remains subdued and we
expect only a very gradual upward movement towards inflation rates below, but close to, 2%
later on.
That's why our monetary policy will continue to provide an appropriate degree of
accommodation. And just be reminded that our forward guidance to keep interest rates at
present or lower levels for an extended period of time remains in place. Let me also assure
you that the ECB has and always will respond to downside risks to price stability if they were
to emerge going forward. Here our policy rate margin still leaves some room for manoeuvre
and our operational framework provides the necessary tools to react swiftly if warranted.
But let's be clear: by ensuring price stability, the ECB is making its contribution to the
economic recovery. Yet, a durable return to robust and sustainable growth requires that
governments persevere in their fiscal and structural reform agenda.