Luis de Guindos: Monetary policy, financial stability and
mediumterm growth in the euro area
Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the
8th Annual Conference of Mediterranean Central Banks, organised by the Croatian
National Bank, the Bank of Spain, the OECD, the IEMed, and the UfM, Split, 14
February 2024.
* * *
Over the past few years the euro area economy has experienced unprecedented
shocks that created exceptional uncertainty and drove inflation to record highs. In
response to these inflationary pressures, we embarked on the most forceful rate hiking
cycle in the history of the euro. Credibility - very much the focus of today's conference
- is a key central bank asset that becomes even more important in times of high
uncertainty. Our policy measures are making a substantial contribution to reducing
inflation, demonstrating our commitment to ensuring that inflation returns to our two per
cent medium-term target in a timely manner.
In my remarks today, I will first review the state of the euro area economy and our latest
monetary policy decisions. I will then turn to financial stability considerations, before
concluding with some thoughts on why action to support the euro area economy is also
needed from other policy actors.
Economic outlook and monetary policy
Our interest rate decisions are guided by three considerations: first, the inflation outlook
in light of incoming economic and financial data; second, the dynamics of underlying
inflation; and third, the transmission of our monetary policy to financing conditions and
the real economy.
Starting with our first criterion, incoming information has broadly confirmed the
mediumterm outlook from our December macroeconomic projections. Economic activity is likely
to have stagnated in the fourth quarter of 2023 and incoming data continue to signal
weakness in the near term. At the same time, some forward-looking survey indicators
point to a pick-up in growth further ahead. Although headline inflation increased in
December to just below 3%, on account of energy base effects reflecting impacts from
the fiscal measures a year ago, the rebound was somewhat weaker than expected.
Aside from energy, all the main components of inflation fell or remained unchanged.
Meanwhile, headline inflation declined again in January. This means that the
disinflationary process is continuing. We also expect inflation to ease further over the
course of this year amid the fading impact of past energy shocks, supply bottlenecks
and the post-pandemic reopening of the economy, and as tight financing conditions
continue to weigh on demand. The disinflationary trend is also evident in both market
and survey-based measures of inflation expectations, which have come down markedly
at shorter horizons and are consistent with our target at longer horizons.
The recent shocks not only drove inflation to record highs but also made
macroeconomic forecasting especially challenging. Looking at the euro area inflation
forecast errors, we have observed two things. First, the absolute size of the errors has
declined. And second, the errors have switched sign: inflation is now coming in
somewhat below, rather than above, the projections. On the one hand, these
developments highlight the lack of bias in the projections. On the other, they reveal a
large uncertainty around the baseline projections. It is therefore essential that we do not
look at the projections in isolation, but rather alongside incoming data.
Let me now turn to the second criterion. Almost all indicators of underlying inflation are
continuing to decline while the range has been narrowing. This confirms that the
disinflationary process is under way. Some of the measures are still high, however, as it
takes time for the impact of past shocks to fully fade. Domestic inflation - which is more
wage-sensitive - has also been moderating but remains elevated and is now at the top
of the range amid falling labour productivity and elevated wage growth in the context of
a robust labour market. Indeed, the unemployment rate is at its lowest level since the
introduction of the euro - despite slowing labour demand and fewer vacancies being
advertised more recently. But the impact of higher unit labour costs on inflation is being
cushioned by lower unit profits.
Moving to the third criterion, our past policy rate increases continue to be transmitted
forcefully into financing conditions. In the course of our current hiking cycle, the
increase in bank lending rates has reached levels not seen since the launch of the euro.
Meanwhile, the weakening in credit has been stronger and faster than in past hiking
cycles. Bank lending conditions remain tight and lending flows are still weak, although
the latest bank lending survey showed first signs that the net tightening of credit
standards and a decline in loan demand are moderating. Tighter financing conditions
are also making their way through the economy by dampening demand, helping to push
down inflation. And given the typical lags in monetary transmission, much of the
economic impact of our past policy rate hikes will continue to materialise over time.
Financial stability
The pass-through to economic activity poses challenges for vulnerable sectors. Higher
interest rates in particular weigh on the debt servicing capacity of highly indebted
corporates. For these firms, any potential downside surprises in growth could result in
subdued earnings, which could further affect debt servicing capacity. Real estate firms
remain particularly vulnerable to losses stemming from the downturn in euro area real
estate markets. The ongoing downturn is particularly acute in the euro area commercial
real estate market, where both activity and prices declined sharply in 2023. On both
sides of the Atlantic, the effects of higher interest rates on this sector have been
compounded by structurally lower demand for some real estate assets following the
pandemic.
Some non-banks and specialised banks remain heavily exposed to interest
ratesensitive sectors, such as highly indebted corporates and real estate. Further
deterioration in these sectors could expose intermediaries to revaluation losses and
investor outflows. This is especially relevant for open-ended investment funds with
mismatches between asset liquidity and redemption terms, including real estate
investment funds with a large market footprint in commercial real estate markets in
several euro area countries. Low levels of liquidity raise the risk of forced asset sales if
macro-financial outcomes deteriorate.
In fact, despite some recent portfolio rebalancing by non-banks, the sector is still
showing high duration, credit and liquidity risk. Entities remain vulnerable to asset price
corrections amid macroeconomic uncertainty and volatile markets. Parts of the
nonbank financial sector also have significant leverage on and off-balance sheet. Fragilities
in the sector pose risks to the financial system, also due to its links to the banking
sector. Banks and non-bank financial institutions can be closely interconnected through
funding channels, ownership linkages and common risk exposures.
In contrast, the euro area banking system has been a source of resilience, with solid
capital and liquidity buffers on the back of strong regulation and robust supervision.
Bank profitability has strengthened in recent quarters, supported by higher interest rates
that compensated lower lending volumes. However, weak lending growth, rising funding
costs and deteriorating asset quality are likely to pose downside risks to profits in the
future. While asset quality indicators have been quite robust, there are early signs of
deterioration in some loan portfolios, including smaller firms and sectors such as
construction and commercial real estate. Nonetheless, the current environment of
macroeconomic uncertainty shows the importance of remaining vigilant - banks should
be prepared for a possible worsening of economic conditions.
Sovereign funding costs have remained stable and contained throughout the tightening
cycle, and as the Eurosystem gradually reduces its presence in the sovereign bond
market. However, weak growth developments or fiscal slippage could reignite concerns
around sovereign debt sustainability, especially in countries where debt is already high.
Challenges ahead
While inflation is on the right track, we need to keep a close eye on the risk factors at
play. On the upside, wage pressures remain high and we do not yet have sufficient data
to confirm they are starting to ease. Profit margins could also prove more resilient than
anticipated. Heightened geopolitical tensions, especially in the Middle East, could raise
energy prices and disrupt global trade.
While we are heading in the right direction, we must not get ahead of ourselves. It will
take some more time before we have the necessary information to confirm that inflation
is sustainably returning to our two per cent target. That is why we will continue to be
guided by data. The next few months will be especially rich in new information on
drivers of underlying inflation as we receive data on latest wage settlements and price
re-setting by firms. We will also have the benefit of new projections in March. In any
case, our future decisions will ensure that our policy rates will be set at sufficiently
restrictive levels for as long as necessary.
Adding on to the challenges discussed so far, the unprecedented shocks of the past
few years have also had profound effects on the euro area's low and declining
mediumterm growth. Euro area potential growth is estimated to have mostly recovered from the
pandemic, thanks to sizeable policy support measures such as job retention schemes
and the expected impact of the Next Generation EU programme. However, potential
growth is very likely to slow down in the future. In this context, other policy areas -
notably fiscal and structural policies - have a crucial role to play in complementing
monetary policy and supporting euro area growth potential.
Potential output is determined by three main factors. First, total factor productivity,
which hinges on supply conditions like the state of technology, as well as market
structures and regulations that facilitate an efficient allocation of available resources
across firms. The outlook for productivity growth, which has been disappointing in
recent decades, especially compared with other major economies, depends in part on
how the green and digital transitions play out. Although this twin transition is expected
to contribute positively in the longer run, there may be an initial cost as companies have
to adjust to new technologies. Second, capital accumulation, which has slowed down
considerably since the great financial crisis. Furthermore, it continues to face an
uncertain outlook given the increased volatility and high frequency of supply shocks,
which may have disrupted investment plans for both tangible and intangible capital.
Third, the contribution of labour, which has been the main engine of potential growth in
the euro area in the past few years due to strong inward migration, increasing
participation of women and the elderly in the labour market, and declining trend
unemployment. It is however expected to dampen, reflecting negative demographic
developments as the euro area population is projected to decline owing to low fertility
1
rates, assuming no further support from migration .
Fiscal and structural policies need to address low growth prospects in the euro area,
while also gradually bringing down high public debt ratios. Structural reforms and
investments that improve the euro area's supply capacity - which would be supported
by the full implementation of the Next Generation EU programme - can help to reduce
price pressures in the medium term, while supporting the green and digital transitions.
In particular, policies to support public and private investment in research and
development, digitalisation and sustainable production processes can increase the euro
area's competitiveness and productivity, which currently lag behind those of the United
States and China. Additionally, structural reforms that promote labour force
participation, support and upgrade education, and improve the matching of skills
between labour supply and labour demand can help to mitigate the impact of
demographics.
Measures of financial integration in the EU also remain stagnant. The financial system
has remained stable, and financial integration has proven resilient to the major shocks
but has seen limited progress. EU debt and equity markets are still very fragmented
along national borders. As we celebrate ten years of banking union, we have to
recognise that it is still incomplete. The capital markets union is also still in its early
stages of development, with no visible progress on the main obstacles of taxation or
2
insolvency law. Reducing national and EU regulatory barriers and deepening the
Single Market are also key to enhance the euro area's competitiveness and
attractiveness for investment.
The unprecedented series of shocks experienced in the EU and around the globe
forced policymakers to focus on swift short-term responses. Both the pandemic and the
energy crisis were met with prompt policy measures. In that context, it was perhaps
understandable that attention was temporarily deflected from the medium-term vision
on EU growth and its challenges. But it is imperative that policymakers now refocus on
the medium-term growth prospects. The findings of upcoming reports on the EU's
competitiveness and the future of the European project will need to be taken into
account. Structural reforms and investment to address low and declining potential
growth require a concerted effort. The cohesion of the euro area and future prosperity
of the EU depend on it.
1
Although total factor productivity, the capital stock and labour supply are all crucial in
any production process, only the first of these elements can sustain economic growth in
the long run for two reasons. First, total factor productivity is not a finite resource. And
second, increasing productivity incentivises firms to invest further in capital and
workers, while making it less costly to do so in an environmentally sustainable way.
2
According to a 2022 European Investment Bank survey, more than 50 per cent of
firms in Greece and Spain and more than one-third of firms in Italy, Portugal and
Cyprus consider bureaucracy, restrictive regulations and high tax burdens to be major
obstacles to investment.