Speech by Dimitris Malliaropulos, Chief Economist and Director of economic analysis and research, during the ‘Greece Trek 2023’ initiative of The Fletcher School of Law and Diplomacy at Tufts University

22/03/2023 - Speeches

Global economic outlook and monetary policy challenges in the face of banking stress

Good morning and welcome to the Bank of Greece. It is a great pleasure for me to talk to you today. We live through very challenging times. The global economy has been hit by a number of shocks over the past three years – pandemic, energy crisis, inflation, monetary policy tightening, and banking turmoil more recently – and we go through a period of elevated uncertainty. Uncertainty comes in waves and the events are so fast that it is sometimes almost impossible to prepare even a small speech for the next day and sleep over it. In fact, I had to review my speech this morning and to make some changes even ten minutes ago. Having said this, please allow me in the following few minutes to share with you my views on the outlook of the global economy, the euro area and Greece, and to give you some food for thought on the challenges for monetary policy of the recent events in the banking sector.

Economic outlook
Global economy
High inflation, monetary policy tightening and pandemic-related disruptions in China dampened global growth in 2022. These factors continue to constrain growth in the first months of 2023, except for disruptions in China, which were short-lived and recovery is already under way. Overall, manufacturing output remained weak by historical standards, but there are tentative signs of stabilisation especially in Europe, supported by declining energy prices. Also, the services sector activity across advanced economies seems to benefit from still resilient labour markets.
Looking further ahead, the reopening in China is expected to provide support to the global economy. However, global growth will remain relatively subdued. The ECB projects world real GDP growth to decline from 3.3% in 2022 to 3.0% this year, before very gradually increasing to 3.3% in 2025. Global growth forecasts have been revised upwards compared to previous projection rounds in late 2022, on the back of an improved outlook for China and stronger growth in the US. However, rising stress in financial markets following the collapse of Silicon Valley Bank in the US increase the uncertainty about the global economic outlook, as it can potentially lead to a tightening of banks’ credit standards.
Although there are increasing signs that global headline inflation has passed its peak, price pressures in the global economy remain high. While lower energy prices and a weaker dollar support a deceleration of inflation, resilient labour markets and strong wage growth point to still strong underlying inflation pressures. In addition, food price inflation remains stubbornly high. This suggests that the process of disinflation will be gradual.
Euro area
Euro area economic activity slowed significantly at the turn of the year, with growth stalling. However, with the energy supplies now more secure and energy prices having eased significantly over the past few months, confidence has improved and the short-term outlook has brightened somewhat. Lower energy prices, dissipating global supply chain bottlenecks and robust labour markets are expected to support aggregate demand. Meanwhile higher interest rates, tighter financing conditions and the unwinding of fiscal support measures during the energy crisis are expected to weigh on growth. Overall, annual average real GDP growth is expected to slow down to 1.0% in 2023 (from 3.6% in 2022), before rebounding to 1.6% in 2024 and 2025.
Headline inflation is expected to fall below 3.0% only at the end of 2023, stabilise in 2024 and moderate further to reach the inflation target of 2.0% in the third quarter of 2025. The expected decline of headline inflation in the medium-term also reflects the gradual impact of monetary policy normalisation.
Greece
The growth rate of the Greek economy in 2022 is estimated at 6.1%. The drivers of this good performance are private consumption, investment and exports. Government support measures, improving consumer and investor confidence as well as reviving tourism and other exports supported economic activity.
In 2023, the growth rate is projected to slow to somewhere between 2% and 2.5%, due to a slowdown in economic activity in the euro area, affecting export growth, and a significant deceleration of private consumption growth. In addition, both fiscal and monetary policies are expected to have a contractionary impact on economic activity in 2023.
In 2024 and 2025, the growth rate is expected to recover, reaching 3.1% and 2.8%, respectively.
The main drivers of growth over the projection period 2023-2025 are expected to be investment and exports and, to a lesser extent, private consumption.
Investment will be supported by the utilisation of available European Union resources. Greece is expected to receive funding of around €40 billion from the EU long-term budget 2021-2027 and €30 billion from the Recovery and Resilience Facility (RRF) until 2026. These resources are expected to attract additional private funds.
Exports will grow in 2023 at a much softer pace compared to 2022, due to weaker economic activity in the euro area and the global economy.
HICP inflation is expected to gradually decelerate to 4.4% in 2023, 3.4% in 2024 and 2.4% in 2025, mainly due to lower energy prices and negative base effects. Core inflation will remain high in 2023. It will decline only gradually over the rest of the projection horizon, due to lower indirect effects from easing energy prices.
Risks to the outlook
The improvement in the outlook is still fragile. The balance of risks to growth remains tilted to the downside and to inflation to the upside. Risks include: (i) an escalation of the war in Ukraine and additional sanctions; (ii) supply-side risks in global commodity markets; (iii) more adverse developments in the residential real estate sector in China; (iv) financial vulnerabilities from high debt and stretched asset valuations, and also in specific financial market segments; and (v) fragmentation of the global trading system.
Challenges for monetary policy

Most central banks have continued to raise their policy rates in the first two and a half months of 2023 in order to bring inflation under control. Global financial conditions continue to tighten as investors respond in a risk-off fashion, particularly after the collapse of Silicon Valley Bank (SVB) on March 10. Credit spreads widened and stock prices of banks dropped. As a result, composite indices of financial conditions tightened sharply, indicating a greater drag on future output growth.

Monetary policy tightening creates interest rate risk in the financial system. Particularly when monetary tightening is fast and synchronised. The current global tightening cycle stands out from a historical perspective. First, it is the most synchronised in the past half-century. By February 2023, more than 90% of economies had hiked their policy rates when, historically, this share has rarely exceeded 50%. Second, central banks have so far raised policy rates at a faster pace than in previous tightening cycles, about twice the historical pace.

The collapse of SVB and two other regional US banks highlights the role of interest rate risk in the financial system. When interest rates were low and asset prices high, banks were buying long-term bonds. When the Fed hiked rates to multiyear highs bond prices dropped and the banks were left with large losses. Capital rules in the US do not require small and medium sized banks to account for the losses from the falling price of bonds they plan to hold to maturity. Only large banks are required to report their bond holdings at market prices (“mark to market”). In fact, unrecognised losses do not matter up to the point they are crystalized, i.e. when the bank is forced to sell (part of) its bond holdings in order to cover its liabilities. This happens when the bank’s depositors start a run on their deposits.

Bank runs wipe out banks’ equity. To prevent a bank run, authorities provide deposit guarantees. Usually these guarantees cover deposits of up to a specific amount, e.g. USD 250 thousand in the US, EUR 100 thousand in Greece. The purpose of these guarantees is to reassure depositors that their money is safe at the banks.

Central banks responded swiftly and effectively to the collapse of SVB to limit contagion. The Fed provided protection for all deposits of two failed banks, independent of size. US Treasury Secretary Janet Yellen said yesterday that guarantees offered to depositors of the two failed banks could be replicated at other institutions. The Fed also initiated the Bank Term Funding Program, which provides emergency liquidity funding against eligible collateral with no haircuts applied. The Swiss National Bank provided liquidity assistance to Credit Swiss of up to CHF 250 bn. Both central banks acted as a lender of last resort to protect their banking system.

The recent turbulence in the banking sector has led investors to dramatically revise their expectations for central bank policy rates. Prior to the Silicon Valley Bank collapse, markets were pricing a US terminal rate of more than 5.5% and an ECB terminal rate of 4%. Once the news broke, investors sharply lowered their expectations, with markets pricing multiple rate cuts by the end of the year due to rising worries about financial stability. To some extent, this may be an overreaction since central banks can use other tools than interest rates to address financial stability risks, while still using rate hikes to tame inflation.

Let me conclude. Financial market stress has increased recently as the central banks’ tightening cycle started to bite. Monetary policy faces a challenge: To safeguard financial stability while continuing to fight inflation. When financial stress increases, financial markets start to question the determination of central banks to continue the course of tightening in order to tame inflation. Instead, investors expect central banks to cut rates in order to avoid breaking anything else in the financial system. However, price stability and financial stability are not conflicting targets and there is no trade-off between the two. Central banks and supervisory authorities do have the policy tools to deliver on both. And they will!