SPEECH
Euro area current policy challenges
Speech by Luis de Guindos, Vice-President of the ECB, at the
CIRSF (Research Centre on Regulation and Supervision of the
Financial Sector) Annual International Conference 2022 "The future
of the EU financial system in a new geo-economic context"
Lisbon, 15 September 2022
I am very pleased to be taking part in this event again and to be back to Lisbon in person.
Following our monetary policy decisions last week, I would like to start with an overview of the euro
area economic outlook that underpinned the Governing Council's deliberations. I will then share our
assessment of the stability of the euro area financial system at the current juncture - the core focus of
today's conference -and outline the ways in which recent economic developments are affecting
financial stability in the euro area.
The euro area economic outlook
After the rebound in the first half of 2022, the euro area is now facing a challenging outlook. The
economy grew by 0.8% in the second quarter of the year on the back of strong consumer spending on
services. Buoyant tourism has been supporting growth also during the third quarter, even as
businesses struggle with high energy costs and continued supply bottlenecks. However, we expect
output growth to slow down substantially. The robust consumer demand that came with the loosening
of pandemic restrictions will lose steam in the coming months. Global demand is falling and euro area
terms of trade have been worsening. Moreover, uncertainty remains high and confidence is falling
sharply. Finally, the very high inflation is dampening spending and production, and these headwinds
are reinforced by gas supply disruptions.
As a result, the latest ECB staff projections for growth have been revised down markedly, with the euro
area economy now set to expand by less than 1% next year. Russia's unjustified aggression towards
Ukraine remains the key risk factor for the growth outlook. In a downside scenario reflecting a
complete and long-lasting cut-off of Russian gas flows, ECB staff project a recession in 2023.
The slowdown in economic activity is set against a deteriorating inflation outlook. Inflation rose further
to 9.1% in August, marking the tenth consecutive month of record-high inflation rates. Energy prices
are still the dominant driver of overall inflation. But price pressures have continued to strengthen and
broaden, in part owing to the impact of high energy costs across more and more sectors. Even when
excluding food and energy, almost half of the items in the inflation basket have recently recorded
annual inflation rates above 4%. While supply bottlenecks have been easing, they continue to
gradually feed through to consumer prices. The depreciation of the euro also adds to these inflationary
pressures.
These factors also explain the upward revisions to the staff projections for inflation. HICP inflation is
projected to be unacceptably high this year and next. Even in 2024, the final year of the projection
horizon, inflation is projected to stand at 2.3%, both for headline and core inflation, excluding the more
volatile energy and food components. While most measures of longer-term inflation expectations
currently stand at around 2%, they warrant continued monitoring for any signs of material above-target
revisions. This is particularly important because the risks to the inflation outlook are primarily on the
upside. In the downside scenario with a more severe energy crisis, headline inflation is projected to be
even higher, reaching 6.9% next year and 2.7% in 2024.
The ECB's recent monetary policy decisions
This outlook for growth and inflation leaves monetary policymakers with no easy choices. Some might
ask why the ECB is normalising its interest rates in the face of an economic slowdown and high
inflation that are largely driven by a cost-push shock.
It is true that we are not in a classic demand-driven overheating episode, and that energy remains the
dominant driver of rising inflation and slowing growth. But at the current low level of interest rates,
monetary policy is still accommodative, thus supporting demand and ultimately also contributing to
price pressures. With inflation at record-high levels, such an accommodative monetary policy stance is
no longer appropriate. Moreover, we need to ensure that inflation expectations remain well anchored
until the current shocks have passed so as to facilitate the return of inflation to our medium-term
target.
Against this background, we decided to raise interest rates by 0.75 percentage points at our
Governing Council meeting last week. This major step frontloaded the transition from a highly
accommodative level of policy rates towards levels that will ensure the return of inflation to our 2%
medium-term target.
We will regularly re-evaluate our policy path in light of incoming information and the evolving inflation
outlook. Our future policy rate decisions will continue to be data-dependent and follow a
meeting-bymeeting approach. Importantly, we need to guard against second-round effects such as the risk of a
persistent upward shift in inflation expectations.
At the same time, we are carefully monitoring the smooth transmission of our monetary policy stance
throughout the euro area. The lasting vulnerabilities caused by the pandemic still pose a risk in this
regard. Therefore, we also decided to continue applying flexibility in reinvesting redemptions coming
due in the pandemic emergency purchase programme (PEPP) portfolio. Moreover, our new
Transmission Protection Instrument (TPI) is available to counter unwarranted, disorderly market
dynamics that pose a serious threat to the transmission of monetary policy across all euro area
countries.
Financial stability in the euro area
Turning to the impact on the financial sector, overall financial stability conditions have deteriorated this
year. Rising inflation and the worsened economic outlook in combination with tighter financing
conditions are aggravating pre-existing vulnerabilities in both the non-financial and non-bank financial
sectors - while in the banking sector profitability is, at least partly, supported by higher interest rates.
Financial markets are vulnerable to changes in expectations about growth and inflation, as well as to
changes in the monetary policy outlook. Tighter financial conditions have already resulted in a
significant market correction in the first half of the year amid rising cross-asset correlations, notably
between equity and bonds, two segments in which investors suffered the largest losses. Some market
segments are still pricing in rapidly declining inflation and a mild growth slowdown, an assessment
which could turn out to be too benign. In addition, investors do not expect the growth slowdown to
significantly challenge corporate solvency or profitability. Over the next 12 months, corporate earnings
are still expected to grow, while speculative-grade default rates are forecasted to pick up only slightly.
But euro area corporates are facing continued headwinds from high input prices, higher borrowing
costs and lower sales. Industrial producer price inflation in the euro area exceeded 40% in June. The
resulting margin squeezes could limit firms' debt servicing capacity, particularly in the case of firms that
are highly indebted and are still suffering from the repercussions of the pandemic. Moreover, high
input costs affect production, especially for manufacturing firms, whose heavy reliance on natural gas
makes them more vulnerable to high energy prices.
Higher inflation is also squeezing households' disposable income. Families have to divert a larger
fraction of their income towards everyday consumption, reducing their debt servicing capacity. As
lowincome households allocate a higher share of their income to food and energy, they are especially
vulnerable to increases in these expenses.
Vulnerabilities in euro area residential real estate markets are also rising in light of continued price
increases and vigorous mortgage lending growth. In the first quarter of 2022 euro area residential real
estate price growth stood at 9.8%, the highest nominal growth rate since the early 1990s. However,
since the beginning of the year, household survey responses on the intention to buy a house have
declined, and banks have lowered their expectations regarding mortgage loan demand, pointing to a
greater potential for house price corrections.
Turning to financial institutions, vulnerabilities in the non-bank financial sector have also increased this
year. The risk that forced selling by investment funds could amplify a market correction remains high,
amid low liquidity buffers. Duration risk has started to materialise and remains elevated, and further
bond portfolio revaluation losses may arise in the context of rising yields.
On a better note, systemic vulnerabilities in the banking sector are assessed as moderate. Bank
profitability has improved owing partly to higher longer-term interest rates. This should, however, not
overshadow rising fragilities related to the worsening macroeconomic outlook. Higher probabilities of
default on corporate exposures and a related increase in provisioning, point to some early signs of
higher bank credit risk due to high energy prices. While the situation is stable overall, with little sign of
fragmentation in funding markets, bank funding costs have increased, with weaker banks remaining
more vulnerable to further rises in their funding costs.
Before concluding, let me recall the topic of transmission. As already mentioned, flexibility in
redemptions coming due in the PEPP portfolio and TPI are important tools for addressing possible
fragmentation from the monetary policy side. But monetary policy would be greatly facilitated if the
banking union were complete. The lack of a common deposit insurance scheme remains an obstacle
on our pathway towards a genuine Economic and Monetary Union.
Conclusion
A period of heightened uncertainty is here to stay for a while, rendering decision-making more
complex. Output growth is slowing down substantially and is expected to stagnate around year-end
and remain low next year at less than 1%, while risks have intensified on the downside. This is set
against a deteriorating inflation outlook with record-high inflation rates expected to stay elevated, well
above our target, with risks primarily on the upside. In this challenging environment, monetary policy
needs to walk a fine line to get it right.
The same applies to the policy mix. Complementary actions of fiscal and monetary policy in their
respective fields of responsibility were effective during the pandemic and continue to be of the
essence in dealing with the current inflation shock. But the scope and nature of fiscal measures should
be different now. Measures need to be focused, selective and targeted to the most vulnerable firms
and households, who are hardest hit by the high inflation levels. Fiscal policy must be designed in a
way that does not give rise to inflationary effects.
Monetary policy needs to be focused on price stability and on delivering our inflation target over the
medium term. Determined action is essential to keep inflation expectations anchored, which in itself
contributes to delivering price stability and avoids second-round effects in inflation. The main asset
that central banks have is credibility, and this asset becomes even more important in times of high
uncertainty.
Thank you for your attention.