The Euro Area: Economic situation, prospects and challenges

THE EURO AREA: ECONOMIC SITUATION, PROSPECTS AND CHALLENGES

Óscar Arce Director General Economics, Statistics and Research Banco de España

Global Interdependence Center – Central Banking Series Madrid, 2018 November 15th

The euro area: economic situation, prospects and challenges

OUTLINE 1. The slowdown of economic growth in the euro area 2. Growth and inflation prospects 3. Rising risks 4. Main challenges

2

The slowdown of economic growth in 2018 • Following strong momentum in 2017, growth in the EA is slowing: Average qoq growth stood near 0,7% in 2017; 0,3% in the first three quarters in 2018 (0,15% in Q3).

• The slowdown has been larger than anticipated, and affects all large euro area countries AVERAGE GDP QUARTER-ON-QUARTER GROWTH

GDP QUARTERLY GROWTH 1.00 %

0.75

1.5

0.8

1.3

0.7

1.1

%

0.6

0.9 0.50

0.25

0.7 0.5

0.4

0.3

0.3

0.1 0.00

0.2

-0.1 -0.3

-0.25

0.5

-0.5

0.1 0.0 EMU

DE

FR

IT

ES

GDP FORECAST B/MPE JUN-18 MPE-MAR18 2017 2018 Q1-Q3 PMI (Right-hand scale) Sources: Eurostat, European Commission, ECB and IHS Markit. (a) Nearest ECB forecast. Last March, June and September ejercises for Q1, Q2 and Q3, respectively

3

External Factors stand behind the larger than expected moderation • Modest growth during 2018 largely reflects global trade moderation: Net trade contribution to growth has been negligible • Transitory factors could have also played a role in some countries (weather, strikes, diesel…)

GLOBAL PMI

REAL GDP GROWTH AND CONTRIBUTIONS FIRST HALF OF 2018

51

1.2 %, PP

50

1.0 0.8

50

0.6 49 0.4 49

0.2

48

0.0 OBSERVED MANUFACTURING

NEW EXPORT ORDERS

NET EXPORTS

BMPE DEC-17 DOMESTIC DEMAND

GDP

Sources: ECB, Eurostat and IHS Markit. Last date: 2018, October for PMI

4

Domestic fundamentals (I): Labour market developments • Domestic fundamentals remained resilient, underpinning economic growth • Job creation has been key in the expansion and is expected to remain robust • Labour market improvements are starting to be transmitted to wage growth. The rise in wages is broad-based by sectors and countries.

12

0.2

0.3

11

0.0

0.2

11

-0.2

0.1

10

-0.4

0.0

10

-0.6

-0.1

9

-0.8

-0.2

9

-1.0

-0.3

8

-1.2 RESIDUAL

EMPLOYMENT (quarter-on-quarter growth) UNEMPLOYMENT RATE (Right-hand scale)

UNEMPLOYMENT GAP

20 18

0.4

20 17

0.4

20 16

12

20 15

0.5

20 14

13

20 11

0.6

20 13

COMPENSATION PER EMPLOYEE GROWTH DESCOMPOSITION Breakdown based on Phillips % estimation Curve 0.6 (Deviations from the mean)

20 12

EMPLOYMENT, UNEMPLOYMENT AND PMI INDEX

INFLATION

PRODUCTIVITY

COMPENSATION PER EMPLOYEE

Source: Eurostat and IHS Markit. Last date: 2018 Q2 to employment and compensation per employee, 2018 September to unemployment and 2018 October to PMI

5

Domestic fundamentals (II): Household income • Strong job creation and (recent) increases in wages are supporting household income, though rising inflation is dampening household purchasing power • Household consumption growth has closely followed income developments, with saving rates near historic lows (except in Germany) HOUSEHOLD GROSS DISPOSABLE INCOME (GDI) AND CONSUMPTION Annual growth rates 4

SAVING RATE Deviations from long-term average (1999-2018 Q2) 5 % GDI 4

3

3 2

2 1

1

0

0

-1

-1

-2 -3

-2

-4 -3 09

10

11

12

13

14

CONSUMPTION (real terms)

15

16

17

18

NOMINAL GDI

REAL GDI

-5

GERMANY SPAIN

FRANCE

EURO AREA

ITALY

Sources: ECB and Eurostat. Last date: 2018, second quarter.

6

Domestic fundamentals (III): Favourable financing conditions • Very loose financial conditions continue to support lending to the private sector, with loan rates at historical lows

BANK LOANS INTEREST RATES 4.0

%

BANK LOANS %

8

5

%

Annual growth rates

4 3.5

7

3.0

6

2.5

5

2.0

4

3 2 1 0 -1 -2

1.5

3

1.0

2 NON-FINANCIAL CORPORATIONS <€1MILLION NON-FINANCIAL CORPORATIONS >€1MILLION HOUSE PURCHASE

-3 -4

NON-FINANCIAL CORPORATIONS HOUSEHOLDS

Sources: ECB. Last date: 2018, September.

7

The role of monetary and fiscal policies • Fiscal policy is expected to have a slight expansionary stance both in 2018 and 2019 • Monetary policy will still provide substantial monetary stimulus in order to support a build-up of domestic price pressures over the medium term FISCAL POLICY STANCE 2

pps of POTENTIAL GDP

% GDP

1

2

MONETARY POLICY EXPECTATIONS Bloomberg survey Reinvestments (Oct. Survey) % of respondents 60

1 50

0

0 40

-1

-1

-2

-2

20

-3

-3

10

-4

-4

30

Expected deposit rate %(Nov. Survey)

0 1Y 2Y 3Y +3y

2012 2013 2014 2015 2016 2017 2018 2019 2020

Length full reinvestment period

BALANCE MEDIAN HIGH FORECAST LOW FORECAST

Source: European Commission (Autumn 2018 forecast) and Bloomberg.

8

GDP prospects • Domestic fundamentals will remain underpinning economic growth, above potential, although the slowdown in external trade and rising uncertainty will weigh in growth GDP GROWTH FORECAST

ECB September 18 June 18 European Commission November 18 July 18 MFI October 18 July 18 OECD September 18 May 18 Survey Professional Forecasters October 18 July 18 Consensus October 18 September 18 Eurobarometer October 18 September 18

2017

2.5 2.5

2.4 2.4

2.4 2.4

2.5 2.5

2018

2.0 2.1

2.1 2.1

2.0 2.2

2.0 2.2

2019

1.8 1.9

1.9 2.0

1.9 1.9

1.9 2.1

2020

1.7 1.7

1.7 …

1.7 …

… …

… …

2.5 2.5

2.5

2.0 2.2

2.0 2.1

2.0

1.8 1.9

1.8 1.8

1.8

1.6 1.6

1.4 …

1.6

2.5

2.1

1.8

…

REAL GDP GROWTH %

%

3

1.5

2

1.0

1

0.5

0

0.0

-1

-0.5 12

13 14 15 16 17 18 1920 QUARTER ON QUARTER GROWTH (RHS) ANNUAL GDP GROWTH

Source: Eurostat and European Commission.

9

Inflation prospects • Growth rates above potential and tightening labour markets support confidence on the sustained convergence of inflation towards the medium-term reference.

• Although core inflation is still hovering around 1%.

INFLATION FORECAST

ECB September 18 June 18 European Commission November 18 July 18 MFI October 18 April OECD September 18 May 18 Survey Professional Forecasters October 18 July 18 Consensus October 18 September 18 Eurobarometer October 18 September 18

2017

1.5 1.5

1.5 1.5

1.5 1.5

…

1.5

2018

1.7 1.7

1.8 1.7

1.7 1.5

…

1.6

2019

1.7 1.7

1.8 1.7

1.7 1.6

…

1.8

2020

1.7 1.7

1.6 …

1.8 1.8

… …

… …

1.5 1.5

1.5 1.5

1.7 1.7

1.7 1.7

1.7 1.7

1.7 1.7

1.7 1.6

1.6 1.7

1.7 1.7

1.7 …

…

1.7

EURO AREA INFLATION 2.5

%

2.0 1.5 1.0 0.5 0.0 -0.5

2013 2014GENERAL 2015 2016 2017 2018 2019 2020 PREVISIÓN BCE SEP-18 EXCLUDING ENERGY AND FOOD PREVISIÓN BCE SEP-18

Source: Eurostat and ECB. Last date: 2018 October

10

Rising risks to the economic scenario • Downside risks have related to both global and domestic factors have intensified:  Protectionism tensions Most estimates of the impact of enacted tariff increases suggest limited effects for the euro area, but larger effects through confidence effects and postponement of investments cannot be discarded  Global policy uncertainties and turmoil in emerging markets: Fiscal expansion in the US and the gradual normalization of Fed’s monetary policy tightenf global financial conditions, with a stronger impact om highly indebted EMEs.  Uncertainty about the degree of slack of the euro area economy: high levels of capacity utilization and some labour shortages point to possible supply side restrictions in some sectors/countries.  Tensions in Italy: So far, contagion effects have been limited, but it cannot be ruled out that further bouts of uncertainty over the Italian fiscal situation might have more significant adverse effects in the future  Risk of no deal for Brexit: it would entail important changes in trade relations after April 2019 with potentially large impact on some financial market segments/insturments

11

Protectionism tensions • Trade tensions have further increased in recent months. Most estimates of the impact of enacted tariff increases suggest limited effects for the euro area.

• But large indirect effects -through confidence and uncertainty leading companies to postpone or cancel investment projects- cannot be discarded REAL GDP IN TRADE TENSIONS SCENARIO (Long term percent deviation from control) 0.0

EU TRADE POLICY

-0.1

• The EU imposed tariffs to $3.3 billion worth of US goods in response to iron and steel tariffs

-0.2 -0.3

US-EU TRADE AGREEMENT

-0.4

oWork towards a free trade area, with zero tariffs on non-auto industrial goods, zero non-tariff barriers and zero subsidies on non-auto industrial goods. EU will increase imports of gas and soya beans from the US. oWork together to reform the WTO and to protect intellectual property rights oThe deal lacks of details and specifics.

-0.5 -0.6 -0.7 -0.8 -0.9 -1.0 USA

CHINA EURO AREA JAPAN

TARIFFS ENACTED

WORLD

POTENTIAL TOTAL EFECTS (a)

Source: IMF, October 2018. (a) Effects of tariffs enacted plus other potential retaliation measures, confidence effects and market reactions

JAPANEU AGREEMENT

ECONOMIC

PARTNERSHIP

oRemoval of the majority of tariffs and opening of agricultural and services markets. oFor the first time, the agreement includes a specific commitment to the Paris climate change.

12

Global policy uncertainty and financial conditions • Fiscal expansion in the US together with tighter monetary policy is leading to a tightening of global financial conditions. Highly indebted EMEs have been the most vulnerable, with strong depreciations of their currencies • The euro has significantly appreciated in nominal effective terms since 2017 10 YEAR INTEREST RATES 3.5

%

GLOBAL FINANCIAL CONDITIONS INDICES

EXCHANGE RATE 125

100 = 1999 Q1

$/€

1.25

123

1.23

121

1.21

2.5

119

1.19

2.0

117

1.17

115

1.15

113

1.13

1.0

111

1.11

0.5

109

1.09

107

1.07

105

1.05

103

1.03

3.0

1.5

0.0 -0.5

USA

GERMANY

Euro Effective Echange Rate EER-38 DOLLAR (Right-hand scale)

2.0

%

TIGHTER CONDITIONS

1.5 1.0 0.5 0.0 -0.5 -1.0 USA Other Systemically Important Advanced Economies CHINA

Sources: ECB and IMF GSFR October 2018. Last date: November, 13.

13

Uncertainties related to the extent of supply side constrains • There is uncertainty regarding the degree of slack of the economy: high levels of capacity utilization and some labour shortages point to possible supply side restrictions • But, there are some signals of remaining slack in the labour market, as broader definitions of unemployment reflect.

EURO AREA.BROADER ESTIMATIONS OF UNDERUTILIZATION OF LABOR

EURO AREA.CAPACITY UTILISATION AND FACTORS LIMITING ACTIVITY 90

60

85

50

80

40

75

30

25

% BROADENED ACTIVE POPULATION

20

15

10 70

20 5

65

10

60 CU Employ_ Demand Equip- Financing None Left-hand scale ment ment

0

RANGE

MÍNIMO

Q3 2018

0 2008

2014

2017-2018

UNDEREMPLOYED LOOKING FOR WORK, BUT NOT AVAILABLE AVAILABLE, BUT NOT LOOKING FOR WORK

Sources: European Commission and Eurostat. Last date: 2018, October for opinion indicators and September 2018 for unemployment. (a) Average since 1999 for capacity utilization and since 2004 for factors limiting activity.

14

Italy • High public debt and low-growth are a notable source of vulnerability.

• Rising sovereign yields and the reactivation of sovereign-bank risk nexus could eventually offset the positive effects arising from fiscal expansion • So far, contagion effects towards other euro area countries have been limited, but further bouts of uncertainty cannot be ruled out 10 YEAR SOVEREIGN YIELDS

ITALY. SOVEREIGN-BANK NEXUS CDS 5-YEARS pb 250

%

9.0 8.0 7.0

200

6.0 5.0

150

4.0 3.0

100

2.0 1.0

50

0.0 -1.0

GERMANY

FRANCE

ITALY

SPAIN

4Ja 8- n11 Ma 16 -M r-1 6 14 ay16 16 Ju - l-1 21 Sep 6 -N -1 24 ov 6 - -1 29 Jan 6 - M -1 a 7 1- r-1 Ju 7 4- nAu 17 9- g-1 12 Oc 7 -D t-1 14 ec 7 -F -1 19 eb 7 -A -1 22 pr 8 - -1 27 Jun 8 -A -1 30 ug 8 -O -1 ct 8 -1 8

0

SOVEREIGN

BANK SECTOR

Sources: ECB and IFS Datastream. Last date: November, 13.

15

The impact of Brexit under a WTO scenario

16

The euro area economy challenges  Monetary policy normalisation will need to be proceed with caution to ensure a continued sustained convergence of inflation towards the medium term reference,  On fiscal policy, the economic expansion and low interest rates call for rebuilding fiscal buffers, particularly in countries with high public debt.  Meeting low productivity and demographic challenges will require further efforts on structural reforms to boost potential long-term growth, improve shockabsorbing capacity and reduce vulnerabilities.  Culmination of Brexit negotiations: the terms of the separation and the nature of the future UK-UE relationship are yet to be defined  In the medium term, the stability of the Eurozone will require deeper integration: -

The institutional reform agenda must progress faster through parallel risk-reduction and risk-sharing measures while enhancing national responsibility.

-

The key priorities are completing the banking union, advancing on the capital market union agenda and designing supranational instruments to help to cope with asymmetric shocks and to support monetary policy in the event of big negative shocks.

17

ADDITIONAL SLIDES

18

Monetary policy normalization  In June 2018, the ECB took first steps to the normalization of monetary policy, based on the substantial progress made towards a sustained adjustment in inflation.  According to last decicions:  Net asset purchases (APP) will end after December, subject to incoming data confirming the medium-term inflation outlook

 Forward guidance on interest rates… “will remain at their present levels at least trough the summer of 2019 and in any case for as long as necessary…”

CENTRAL BANK'S BALANCE SHEET OFFICIAL INTEREST RATES % GDP 2017 %  5 Reinvestments will continue “for an extended period of time after the 45 end of our net assets purchases, and in40any case for as long as necessary” 4

35 30

3

25

2

20 15

1

10

0

5 0

-1 EUROSYSTEM: MAIN REFINANCING OPERATIONS EUROSYSTEM: DEPOSIT FACILITY RATE FEDERAL RESERVE: FEDERAL FUNDS RATE

EUROSYSTEM

FEDERAL RESERVE

Sources: ECB, Federal Reserve. Last date: November 7 to interest rate and November 1 to balance

19

Monetary accommodation is still needed.

Importance of central bank communication

 Heightened risks reinforce the case for being patient, prudent and persistent in the monetary policy stance. A significant stimulus is still needed to support a build-up of domestic price pressures over the medium term.  The support will continue to be provided through:  Reinvestments. Available empirical evidence shows that the size of the central bank balance sheet matters more that the flow of net asset purchases in reducing long term interest rates (De Santis and Holm Hadulla, 2017). The details of the reinvestment strategy are yet to be defined.  Enhanced Forward Guidance. Communication has become critical to guide interest rates expectations and ensure a smooth normalization process.  From March 2016 until June 2018: “we expect the key ECB interest rates to remain at their present levels for an extended period of time and well past the horizon of our net asset purchases”.  In June 2018 the GC reinforced the FG strategy with a two-pronged statement:  (1) a date based element, “at least trough the summer of 2019”, and  (2) a state contingent element, which states that interest rates will remain unchanged “in any case as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to 2% over the medium term”.

20

The euro area economic expansion

21

Eurozone financial conditions index

22

Domestic uncertainties: italy

23

Monetary policy has been instrumental to the recovery since mid 2014 ď&#x192;&#x2DC; The ECB has provided extraordinary monetary stimulus since mid 2014 with: (1) ultra-low/ negative interest rates; (2) balance sheet expansion; (3) forward guidance ď&#x192;&#x2DC; The impact on GDP growth and inflation can be estimated around 2.3 and 1.7 p.p. in the period 2015-2018

24