Introductory remarks by Dimitris Malliaropulos, Chief Economist and Director of Economic Analysis and Research of the Bank of Greece, at the 17th European SSM Round Table of the International Bankers Forum, hosted by the Bank of Greece
11/05/2023 - Speeches
“The challenging road ahead for the euro area economy and monetary policy”
When we talk about the challenging road ahead for the euro area economy, it is important to keep in mind our starting point. Over the past three years, our economies have been hit by a triple shock: the powerful blow of a pandemic, followed by a war in Europe and an energy crisis. Each one of these shocks is a low probability-high impact event and the fact that they occurred almost one after the other implies a compounded adverse economic impact. The pandemic and the war in Ukraine are both adverse supply shocks, strongly pushing the euro area economy towards stagflation. But in order to put the euro area outlook into its appropriate context, let me start by saying a few words about the global economic environment.
Economic slowdown and persistent inflation
Signs of a soft landing of the global economy from the unprecedented economic shocks have recently somewhat moderated, on the back of still high inflation and rising uncertainty over the side effects from the synchronised global monetary tightening cycle. In some countries, banking sector vulnerabilities have come to the fore, raising fears of a broader financial turmoil, weakening fundamentals in the nonbank financial sector, and sizeable adverse cross-country economic and financial spillovers. On the positive side, global supply-chain bottlenecks continue to ease, China’s economy is on a rebounding growth path, and emerging market economies are set to mark on average stronger growth this year. Still, medium-term forecasts of global growth at around 3% portrait fragile global activity.
Headline inflation has begun to abate, but core inflation is still too high and persistent. Central banks have further raised policy rates since mid-March. Nevertheless, investors revised down their policy rate expectations and pushed up risky asset prices. This pattern highlights a renewed disconnect between markets and central bank communication.
Against this backdrop, the euro area economic outlook has brightened somewhat compared to downbeat expectations of a recession a few months ago. In the short term, prospects are largely shaped by an economic slowdown but still persistent inflationary pressures. Fiscal policy measures to tackle the energy crisis continue to support real incomes alongside a resilient labour market. The latest GDP reading of just 0.1% growth in the first quarter of 2023, following stagnating activity in the previous quarter, is broadly in line with the ECB’s March macroeconomic projections of weak growth this year. Short-term inflation developments are underpinned by a larger-than-expected decline in energy inflation since February. This is good news as the supply shock that caused inflation to rise steeply in the first place is now unwinding faster. Energy supplies in Europe are now more secure and energy prices have eased significantly, rebalancing the energy market and improving confidence. In this regard, headline inflation in the euro area is on a declining path, though its decline is a bit less than expected on the back of more persistent core inflation, which however fell marginally in April, after a long period of continuous rises.
In 2023 as a whole, headline inflation is likely to decline considerably thanks to monetary policy normalisation, a negative energy price contribution, an easing of supply-chain bottlenecks and an appreciating euro. According to the March 2023 ECB staff projections, headline inflation will reach the ECB target of 2% in the third quarter of 2025. However, underlying inflation dynamics are set to remain elevated reflecting broadened price pressures to most components in the consumption basket as well as a pick-up in wage growth amid still tight labour markets. But underlying inflation should ease later in the year as the lower consumer energy prices would gradually feed through.
Over the medium term, as far as growth is concerned, the impetus from current tailwinds will be mitigated by the lagged impact of the ECB’s policy normalisation, some further dampening effects from the tightening of financing conditions, a gradual withdrawal of fiscal support, but also concerns about energy supply in the winter of 2023-24. All in all, growth is set to hover close to 1.6% in the next two years.
Having said that, the prospects for euro area’s activity and inflation are subject to notable risks, even in the absence of additional shocks. On the external side, I would highlight risks of geo-economic fragmentation in international trade and finance that are firmly rising. Renewed commodity price pressures on the back of strengthening demand in China as the economy re-opens could also trigger adverse terms-of-trade and income shocks. Domestically, concerns, in view of the recent banking events, of an abrupt repricing of risks by financial markets may hinder growth and financial stability. The tight monetary policy stances needed to bring down inflation and sustain it near the target is an additional challenge that could prolong anemic growth. Finally, stronger wage and profit growth could keep core inflation higher for longer, increasing the risk of wage-price spirals.
Do we foresee bright spots in the outlook despite turbulent times?
For a start, growth in the euro area has remained resilient and the economy has weathered the energy crisis without falling into a recession, signaling robust fundamentals, including a strong labour market and a large pile of private savings accumulated during the pandemic. Most importantly, policymakers have stood ready to take forceful action to mitigate the economic fallout from the recent shocks.
Second, over the past six months the euro has appreciated significantly, not only against the US dollar but also in nominal effective terms, supporting the central bank’s struggle to get inflation down to its 2% target.
Finally, in this volatile economic environment, Greece seems to be developing into a success story for the euro area, in terms of achieving a sizeable fiscal adjustment, namely a primary budget surplus of about €3 billion in the first quarter of 2023, and a reduction in gross public debt by 23 percentage points of GDP in 2022, somewhat alleviating the fiscal constraints to cope with potential new challenges ahead. In 2022, Greece has also marked one of the highest growth rates in the euro area, large increases in FDI, including those by big multinationals establishing research hubs and service centres, a significant drop in inflation and a forthcoming sovereign rating upgrade to the investment grade, reflecting the positive impact of past and current reforms and the increased confidence in the economy’s prospects.
Monetary policy tightening and financial stability risks
So, a challenge we are facing in the euro area is to sustain solid economic growth and at the same time tame persistent inflation and secure price stability. Confronted with a daunting task, the ECB embarked in July 2022, later than other central banks in major advanced economies, on a journey of monetary policy tightening of unprecedented speed and scale. Since July 2022, the ECB’s deposit facility rate has been raised by a cumulative 375 basis points, bringing it at 3.25% today.
Let me note that the current global tightening cycle stands out from a historical perspective as it is the most synchronised one in the past half century. By early 2023, more than 90% of economies had hiked their policy rates when, historically, this share has rarely exceeded 50%. Moreover, central banks have raised policy rates at a faster pace than in previous tightening cycles, about twice the historical pace in emerging markets. This synchronised and aggressive global monetary policy tightening amplifies cross-border spillovers of monetary policy. For instance, several studies[1] indicate that the Fed tightening elicits large contractionary effects on real activity and financial conditions in the euro area. Also, the US dollar has appreciated sharply for most of the past year (before weakening more recently), triggering a negative terms-of-trade shock for the euro area which poses additional challenges to monetary policy and financial stability.
Recently, policy rate expectations of market participants were pared back reflecting easing inflation expectations and the financial market turmoil triggered by the SVB collapse. Although the increase in short-term risk-free rates can weigh on economic growth, positive market perceptions about a faster deceleration of inflation and expectations that the Fed will start cutting interest rates already this fall have supported risky assets, narrowing corporate bond spreads and raising equity prices.
A key question is whether the extraordinary and multiple shocks of the pandemic, the war in Ukraine, supply chain bottlenecks and the energy crisis may affect the speed and strength of the transmission of monetary policy compared to past regularities. The transmission largely depends on whether the inflation shock is demand- or supply-driven. Although the rise in inflation started as a supply-driven shock, currently both demand and supply seem to drive inflationary developments. Market-based measures suggest that medium-term inflation expectations remain anchored, but they also appear to be pointing to a prolonged period of above-target inflation. Having said that, past episodes of rising inflation clearly suggest that monetary policy tightening has been successful in containing inflation.[2] Moreover, ongoing empirical analysis at the Bank of Greece for the G7 and the euro area peripheral countries shows a steepening of the Phillips curve since the global financial crisis, a possible explanation being deglobalisation. A steeper Phillips curve implies that monetary policy becomes more effective, i.e. the central bank does not have to hike interest rates so aggressively in order to steer inflation to its target. In other words, the terminal interest rate should be lower compared to previous tightening cycles.
In addition to the policy rate hikes, the ECB started in March of this year a measured and predictable reduction of its APP portfolio by €15 billion per month on average until end-June. The rationale for quantitative tightening is trifold: regain policy space, support the intended monetary policy stance, and mitigate the adverse effects of a large central bank balance sheet on both the central bank and the financial markets. By maintaining a large balance sheet, the central bank can be exposed to higher credit and duration risks and can also be criticised of financial and fiscal dominance. As a side effect of quantitative easing, financial markets may suffer from scarcity of safe assets, which forces market participants to pay a “scarcity premium” on the price of those assets, driving sovereign yields lower and delaying or even impairing the intended monetary tightening. It is also important to note that safe assets are playing an important role as collateral in the repo market for both banks and non-bank financial intermediaries. Hence, during times of heightened market volatility and increased demand for liquidity, it is important to ensure that there is an adequate amount of good collateral in the hands of financial intermediaries to allow a smooth functioning of the repo market.
In anticipation of tapering by the ECB, investors had already started rebalancing their portfolios, gradually reversing some of the term-premium compression in sovereign bond yields induced by the ECB’s past asset purchases. [3] Therefore, the prospects of quantitative tightening have likely complemented policy rate hikes in the fight against inflation, but the jury is still out since we haven’t seen yet a meaningful decline in the size of the APP portfolio. If quantitative easing has driven bond yields down by reducing the net supply of safe assets available to private investors, as a number of studies suggest[4], then reducing the size of the central bank’s balance sheet too fast may lead to a significant increase in the term premia of sovereign bond yields and an accentuation of financial stability risks.
This brings me to the other big challenge the euro area is facing, that of preserving financial stability. Higher interest rates and quantitative tightening expose financial sector vulnerabilities. Tighter financial conditions have increased the debt servicing burden of borrowers, raising the risk of debt distress and defaults. Excessive levels of private indebtedness and stretched asset prices make the effects of rising interest rates possibly non-linear. Monetary policy tightening has also triggered asset repricing, generating liquidity mismatches and unrealised losses on the bond holdings by financial institutions. Recent events in the financial sector highlight that strains in both banks’ and non-banks’ loan and bond portfolios are building up and could be further compounded by potential losses from direct asset exposures to market segments, like the real estate sector, that are vulnerable to sudden corrections. This could further weaken lending to the private sector and intensify the drag on economic activity.
Nonetheless, until now, financial stability risks in the euro area have been manageable. Banks’ short-term profitability has improved on the back of significantly higher net interest margins and, so far, muted impairments and provisions on banks’ balance sheets.[5] The euro area’s banking sector remains well-capitalised, highly liquid and closely supervised. The regulatory and institutional reforms introduced since the global financial crisis have strengthened banks’ resilience to shocks, as also shown by the limited contagion from the SVB and Credit Suisse events to the euro area’s financial sector. But we should remain vigilant and apt to deploy macro- and micro-prudential measures to bolster the resilience of the banking sector on the basis of country-specific macro-financial and banking conditions and coordinate to limit the risk of procyclicality.[6]
Financing EU’s future growth
In the medium term, the biggest challenge for the euro area is to remain competitive and productive in a rapidly changing and possibly more fragmented world. Climate change and the green transition, digitalisation, artificial intelligence and bio-tech are transforming economic activity and international trade very fast. Countries are competing to secure critical production inputs and enhance their industrial base through innovation. The challenge for Europe is to secure its place in this new global order. How are we going to finance EU’s future growth? Let me highlight two aspects.
First, EU member states and firms have access to a plethora of EU funds that channel public capital to investment, often leveraged multiple times through the mobilisation of private capital. The most prominent post-pandemic EU instrument is NextGenerationEU, amounting to €750 billion, with the Recovery and Resilience Facility (RRF) at its core. The RRF funding is a historic opportunity to close the investment gap of recent years, address chronic structural problems, strengthen the resilience and dynamism of the European economies and bolster the EU’s strategic autonomy. Under the RRF national plans, reforms and investments become more interlinked and create strong synergies and multiplier benefits within and across the EU economies in the form of favourable spillovers and spillbacks.
Second, in contrast to the US, Europe still lacks a large, deep and liquid financial market from which companies can raise finance. Amid tighter monetary conditions, it is important to accelerate the Capital Markets Union to diversify financing sources, increase funding for start-ups, attract foreign capital and narrow the gap with the US and Asia. Addressing capital market fragmentation and complexity through deeper harmonisation of national legislation is key.
The ambitious new growth model for Europe centred on a greener and more digital future will require an enormous amount of financing from traditional and less traditional sources, banks and non-bank financial institutions. The stakes are high, the risks are high but higher is the opportunity and it should not be missed. Thank you!
[1] Ca' Zorzi, M., Dedola, L., Georgiadis, G., Jarociński, M., Stracca, L. and Strasser, G. (2020), "Monetary policy and its transmission in a globalised world", Discussion Papers, ECB Working Paper Series, No 2407, ECB, Frankfurt am Main, May.
[2] IMF (2022), Wage dynamics post-Covid-19 and wage-price spiral risks. WEO Chapter 2, International Monetary Fund, Washington, D.C.
[3] Speech by Isabel Schnabel on "Quantitative tightening: rationale and market impact",2.3.2023.
[4] Vayanos, D.and J.-L. Vila (2021), A Preferred‐Habitat Model of the Term Structure of Interest Rates - Vayanos - 2021 - Econometrica - Wiley Online Library. Malliaropulos, D. and P. Migiakis (2023), “A global monetary policy factor in sovereign bond yields”, Journal of Empirical Finance 20, 445-465, https://doi.org/10.1016/j.jempfin.2022.12.011.
[5] Speech by Luis de Guindos on "Outlook for the euro area economy and financial stability", 1.4.2023.
[6] ESRB (2022), Warning of the ESRB on vulnerabilities in the Union financial system, European Systemic Risk Board, Frankfurt am Main.