Economic and monetary developments

Overview

At its monetary policy meeting on 13 December, the Governing Council decided to end the net asset purchases in December 2018, while keeping the key ECB interest rates unchanged and enhancing the forward guidance on reinvestment. While incoming information has been weaker than expected, reflecting softer external demand but also some country and sector-specific factors, the underlying strength of domestic demand continues to underpin the euro area expansion and gradually rising inflation pressures. This supports the Governing Council’s confidence that the sustained convergence of inflation to its aim will proceed and will be maintained even after the end of the net asset purchases. At the same time, uncertainties related to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility remain prominent. Therefore, significant monetary policy stimulus is still needed to support the further build-up of domestic price pressures and headline inflation developments over the medium term. The Governing Council’s forward guidance on the key ECB interest rates, reinforced by the reinvestments of the sizeable stock of acquired assets, continues to provide the necessary degree of monetary accommodation for the sustained convergence of inflation to its aim. In any event, the Governing Council stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards its inflation aim in a sustained manner.

Economic and monetary assessment at the time of the Governing Council meeting of 13 December 2018

While global economic activity has remained resilient, it has become more uneven and signs of moderating momentum are emerging. The maturing global economic cycle, waning policy support across advanced economies and the impact of tariffs between the United States and China are weighing on global activity. Global trade growth has decelerated somewhat, and uncertainties about future trade relations have risen. At the same time, financial conditions remain accommodative in advanced economies, whereas they have tightened for some emerging markets. Looking ahead, global economic activity is expected to decelerate in 2019 and remain steady thereafter. Global inflationary pressures are expected to rise slowly as spare capacity diminishes.

Long-term risk-free rates have declined in the context of heightened geopolitical uncertainty and a perceived deterioration in the macroeconomic outlook since the Governing Council’s meeting in September 2018. Euro area sovereign bond spreads have been largely stable, with the exception of those for Italy, which have exhibited considerable volatility. Although corporate earnings expectations remain robust, some downward revisions, in addition to a repricing of risk, have led to lower equity and bond prices of euro area corporations. In foreign exchange markets, the euro has broadly weakened in trade-weighted terms.

Euro area real GDP increased by 0.2%, quarter on quarter, in the third quarter of 2018, following growth of 0.4% in the previous two quarters. The latest data and survey results have been weaker than expected, reflecting a diminishing contribution from external demand and some country and sector-specific factors. While some of these factors are likely to unwind, this may suggest some slower growth momentum ahead. At the same time, domestic demand, also backed by the Governing Council’s accommodative monetary policy stance, continues to underpin the economic expansion in the euro area. The strength of the labour market, as reflected in ongoing employment gains and rising wages, still supports private consumption. Moreover, business investment is benefiting from domestic demand, favourable financing conditions and improving balance sheets. Residential investment remains robust. In addition, the expansion in global activity is still expected to continue, supporting euro area exports, although at a slower pace.

This assessment is broadly reflected in the December 2018 Eurosystem staff macroeconomic projections for the euro area. These projections foresee annual real GDP increasing by 1.9% in 2018, 1.7% in 2019, 1.7% in 2020 and 1.5% in 2021. Compared with the September 2018 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised slightly down in 2018 and 2019. The risks surrounding the euro area growth outlook can still be assessed as broadly balanced. However, the balance of risks is moving to the downside owing to the persistence of uncertainties related to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility.

According to Eurostat’s flash estimate, euro area annual HICP inflation declined to 2.0% in November 2018, from 2.2% in October. On the basis of current futures prices for oil, headline inflation is likely to decrease over the coming months. Measures of underlying inflation remain generally muted, but domestic cost pressures are continuing to strengthen and broaden amid high levels of capacity utilisation and tightening labour markets, which is pushing up wage growth. Looking ahead, underlying inflation is expected to increase over the medium term, supported by the ECB’s monetary policy measures, the ongoing economic expansion and rising wage growth.

This assessment is also broadly reflected in the December 2018 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.8% in 2018, 1.6% in 2019, 1.7% in 2020 and 1.8% in 2021. Compared with the September 2018 ECB staff macroeconomic projections, the outlook for HICP inflation has been revised slightly up for 2018 and down for 2019. HICP inflation excluding energy and food is expected to rise from 1.0% in 2018 to 1.4% in 2019, 1.6% in 2020 and 1.8% in 2021.

Broad money (M3) growth picked up in October 2018, amid an ongoing shift towards more self-sustained sources of money creation as the monthly net asset purchases under the asset purchase programme were reduced. Lending to the private sector continued to grow and remained the largest driver of broad money growth, albeit with some signs of slowing down, mainly for loans to non-financial corporations. At the same time, bank funding and lending conditions have remained very favourable. The pass-through of the monetary policy measures put in place since June 2014 continues to significantly support borrowing conditions for firms and households, access to financing – in particular for small and medium-sized enterprises – and credit flows across the euro area.

The euro area general government budget deficit is projected to have declined significantly in 2018 but to increase somewhat next year. The fall in 2018 was mainly the result of favourable cyclical conditions and declining interest payments. The aggregate fiscal stance for the euro area is expected to be broadly neutral in 2018, to loosen in 2019 and 2020, and to turn neutral again in 2021.

Monetary policy decisions

Based on the regular economic and monetary analyses, the Governing Council made the following decisions. The Governing Council decided to keep the key ECB interest rates unchanged and continues to expect them to remain at their present levels at least through the summer of 2019, and in any case for 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. Regarding non-standard monetary policy measures, the Governing Council decided that net purchases under the asset purchase programme (APP) will end in December 2018. At the same time, the Governing Council enhanced its forward guidance on reinvestment. Accordingly, the Governing Council intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when the Governing Council starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

External environment

While global economic activity has remained resilient, it has become more uneven and signs of moderating momentum are emerging. The maturing global economic cycle, waning policy support across advanced economies and the impact of tariffs between the United States and China are weighing on global activity. At the same time, financial conditions remain accommodative in advanced economies, while they have remained tight for some emerging markets. Global trade growth has decelerated somewhat, and uncertainties about future trade relations have risen. Looking ahead, global economic activity is expected to decelerate in 2019 and be steady over the following two years, as policy support gradually diminishes and China transitions to a lower growth path. Global inflationary pressures are expected to rise slowly as spare capacity diminishes. Risks to global activity are skewed to the downside.

Global economic activity and trade

While global economic activity has remained resilient, signs of moderating momentum are emerging. The global economy continued to expand at a steady pace in the second quarter of 2018, supported by a rebound in activity in several advanced economies, including the United States, the United Kingdom and Japan. The growth rate for the third quarter in the United States still points to resilient activity, while in the United Kingdom GDP growth was strong, partially reflecting an increase in government spending; the Japanese economy contracted in the same period, which was largely due to temporary factors related to natural disasters. Across emerging market economies (EMEs), the growth picture is more mixed. Economic activity held up in China in the third quarter, but weakened substantially in EMEs that had been subject to financial turmoil earlier this year.

Survey-based evidence suggests that activity will decelerate in the near term. The global composite output Purchasing Managers’ Index (PMI) excluding the euro area has been gradually retreating since early 2018, driven mainly by a continued deceleration in global manufacturing activity (Chart 1). The services sector performed better than manufacturing in the year to November, notwithstanding some volatility in the figures. Consumer confidence has recently declined, albeit from high levels.

Financial conditions in advanced economies remain accommodative, while the picture for EMEs is relatively mixed. In China, financial conditions have eased owing to action by the People’s Bank of China reacting to the worsening outlook for activity, amid domestic imbalances and rising trade tensions. However, financial conditions in the EMEs that were among the hardest hit by the summer financial market turbulence – including Argentina and Turkey – remain tight and are weighing significantly on their outlook for activity. Overall, global risk sentiment has not fully recovered since the summer months and financial investors have been discriminating against EMEs with significant imbalances, high external financing needs and limited room for policy support. Looking ahead, a further rise in US interest rates as the Federal Open Market Committee proceeds with its gradual policy normalisation, coupled with a stronger dollar, could lead to a further tightening of financial conditions across EMEs.

In the near term, the current cyclical momentum is expected to support global activity. Advanced economies continue to benefit from accommodative monetary policies and supportive financial conditions. A sizeable procyclical fiscal stimulus in the United States, including lower taxes and increased expenditure, will also provide an impetus to global growth, amid a broader shift towards more expansionary fiscal policies among advanced economies.

Looking further ahead, activity is projected to decelerate in 2019 and be steady in the following two years. This reflects the projected cyclical slowdown across advanced economies and in China. Output gaps are already closed in many advanced economies, and spare capacity is expected to narrow across emerging market economies over the medium term. The intensification of trade tensions between the United States and China should weigh on activity in both countries. While the global impact is still judged to be relatively limited, heightened uncertainty about future trade relations may adversely affect confidence and investment. Moreover, policy support is likely to gradually diminish. For the United States, the baseline projection is that the boost to growth from fiscal stimulus will peak in 2019; in Japan fiscal stimulus is already expected to fade this year. On the monetary policy side, a gradual tightening is expected in the United States, as reflected in current financial market prices, and should contribute to a modest tightening of global financial conditions. The expected path for global activity also reflects a recovery in several emerging market economies, especially those affected by the recent financial market turbulence. Overall, the pace of global expansion is expected to settle at rates below those seen before the 2007-08 financial crisis.

Turning to developments across countries, in the United States activity is expected to remain resilient in the near term. Strong labour market conditions, solid corporate profits and still favourable financial conditions should support growth. The procyclical fiscal stimulus will continue to underpin the favourable growth outlook next year, while the bilateral trade conflict with China is expected to weigh somewhat on activity and investment. Moreover, the mid-term elections resulted in split control of Congress, thereby increasing the likelihood of legislative gridlock.

In Japan, activity is expected to rebound in the near term, but the pace of the economic expansion is projected to decelerate gradually thereafter. The adverse impact of a series of natural disasters weighed on activity in the third quarter of 2018, although growth is expected to recover in the fourth quarter. Looking ahead, activity will benefit from accommodative monetary policy, but increasingly binding capacity constraints are expected to weigh on growth. Wages are rising moderately, amid a tight labour market, which should support household spending.

In the United Kingdom, the outlook is for moderate growth, as domestic demand remains subdued. Surprisingly solid activity in the third quarter was supported by several transitory factors. However, high uncertainty continued to weigh on business investment, which extended its decline to three consecutive quarters. The near term outlook remains subject to considerable uncertainty due to the upcoming voting on the EU withdrawal agreement in Parliament.

In central and eastern European countries, GDP growth is projected to remain robust in the near term. Activity is supported by strong investment linked to EU funds, solid consumer spending and improvements in the labour market. Over the medium term, activity is expected to decelerate towards potential.

Activity in China has remained strong, supported by solid consumption, government policy support and robust exports, possibly due in part to frontloading of orders in anticipation of higher tariffs. However, in the near term a slowing housing market and the lagged effects of earlier deleveraging efforts should weigh on growth. Also, new trade tariffs implemented by the US Administration are expected to adversely impact activity. Their overall effect in China is assumed to be relatively contained, though, owing to the recently enacted policy stimulus measures. Over the medium term, progress on the implementation of structural reforms is expected to result in an orderly slowdown and some rebalancing of the Chinese economy.

Economic activity is projected to strengthen in the large commodity-exporting countries. In Russia, the economic recovery is expected to continue, supported by the past increase in oil prices, and improving domestic demand amid rising disposable income and credit. The recent fall in oil prices implies some downside risk to the outlook for the Russia economy. Over the medium term, growth is seen benefiting somewhat from the recently announced multi-year government spending plan. In Brazil, activity is expected to accelerate in the near term, as the impact of political uncertainties and the disruptions from the truckers’ strike fades away. Further ahead, an improved labour market and continuing monetary accommodation should support consumption, as inflationary pressures remain contained.

Turkey is expected to undergo a difficult adjustment in the coming months. Despite the recent stabilisation of the lira, financial conditions remain tight. Combined with high inflation and procyclical monetary and fiscal policies, this is projected to weigh on economic activity.

Global trade growth has moderated in 2018, following its strong momentum in 2017. The volume of global merchandise imports has been relatively volatile this year. After stalling in the second quarter of 2018, trade increased by 1.5% in the third quarter on account of stronger EME imports. Indicators for subsequent periods provide mixed signals. While the new export order PMI would suggest more underlying weakness in global trade (Chart 2), other indicators – such as global industrial production or the Tech Pulse index – suggest steady growth.

Trade tensions between the United States and China have escalated. The US Administration has announced tariffs targeting an additional USD 200 billion of Chinese exports to the United States, and China has retaliated with tariffs on an additional USD 60 billion of exports from the United States, both effective as of 24 September 2018. This follows previously enacted tariffs targeting USD 50 billion of these countries’ bilateral merchandise trade, as well as tariffs targeting steel and aluminium exports to the Unites States and retaliation by China. These measures are expected to weigh on activity and trade in the United States and China, yet their global impact us expected to remain relatively contained.

Looking ahead, global trade is expected to remain subdued. While the impact of tariffs remains contained so far, it is expected to affect merchandise trade between the United States and China to a larger extent next year. Over the period 2020-21, global trade is projected to grow broadly in line with activity.

Global economic growth is projected to decelerate next year and be steady in the following two years. According to the December 2018 Eurosystem staff macroeconomic projections, world real GDP growth (excluding the euro area) is expected to stand at 3.8% this year before decelerating to 3.5% in 2019. Over the period 2020-21, it is projected to be broadly steady. This projection path reflects the expected slowdown in the near term in some emerging economies, as financial conditions have tightened. Further ahead, the expansion in advanced economies is projected to slow towards potential growth. Moreover, the pace of expansion in China is expected to moderate gradually. Growth in euro area foreign demand is projected to decline from 4.3% this year to 3.1% in 2019, before rising slightly in the medium term. Compared with the September 2018 ECB staff projections, global GDP growth has been revised slightly downwards for 2018 and 2019, reflecting the weaker outlook in some EMEs. Growth in euro area foreign demand has also been revised downwards, for 2019 and 2020, reflecting the effect of higher tariffs and weaker projected economic activity.

Risks for global activity are on the downside. A further escalation of trade disputes could significantly weigh on global growth. While the temporary truce between the United States and China sent a positive signal, there remains considerable uncertainty as to whether the talks will lead to a significant de-escalation of US-China trade tensions. Other downside risks relate to a faster than expected tightening of global financial conditions leading to broader stress in emerging markets, uncertainties regarding China’s reform process, and political and geopolitical uncertainties, including risks related to Brexit.

Global price developments

Although very volatile, oil prices have recently declined significantly. Volatility in the oil price has largely reflected news from the supply side of the market, although, more recently, expectations of lower global demand have weighed on the oil price. The Brent crude oil price peaked at USD 86 per barrel in early October amid expectations of significantly lower oil exports from Iran owing to looming US sanctions and a decision by OPEC and Russia to keep their production steady. Since then, a confluence of positive news on the supply side, including declarations of sufficient spare supply capacity by Saudi Arabia and Russia and the announcement of temporary waivers from US sanctions for several large economies importing oil from Iran, have contributed to an oil price decline. More recently, expectations of lower global demand for oil have also pushed the price down. These developments have meant that the oil price assumption underpinning the December 2018 Eurosystem staff macroeconomic projections was about 5.8% lower for 2019 and 3.2% lower for 2020 than in the previous projections. Since the cut-off date for the projections, however, the price of oil has fallen further, reaching USD 59 per barrel on 12 December.

Before the recent fall in oil prices, past increases put some upward pressure on global consumer price inflation. Annual consumer price index inflation in the countries of the Organisation for Economic Co-operation and Development (OECD) rose to 3.1% in October. Excluding food and energy, inflation was unchanged at 2.3%, pausing on a very moderate upward trend observed over the past year (Chart 3). At the same time, despite tightening labour markets across advanced economies, wage pressures remain relatively subdued.

Looking ahead, global inflationary pressures are expected to remain contained. In the short term, the export prices of the euro area’s competitors are expected to increase following the past pick-up in oil prices and higher inflation across several EMEs affected by the summer financial turmoil. Further ahead, the recent decline in oil prices and the current oil futures curve, which suggests gradually declining prices over the medium term, indicate a falling contribution from energy prices to inflation. On the other hand, diminishing spare capacity at the global level is projected to put some upward pressure on inflation.

Financial developments

Since the Governing Council’s meeting in September 2018 global long-term risk-free rates have declined in the context of heightened geopolitical uncertainty and a perceived deterioration in the macroeconomic outlook. Euro area sovereign bond spreads have been largely stable, with the exception of Italy where they have exhibited significant volatility. Although corporate earnings expectations remain robust, some downward revisions, in addition to a repricing of risk, have led to falls in the equity and bond prices of euro area corporations. In foreign exchange markets, the euro has broadly weakened in trade-weighted terms.

Long-term yields have declined in the euro area and in the United States. During the period under review (from 13 September to 12 December 2018), the euro area ten-year risk-free overnight index swap (OIS) rate fell overall to 0.72% (down 4 basis points) and the GDP-weighted euro area ten-year sovereign bond yield fell to 1.09% (down 1 basis point). In the United States (see Chart 4), the ten-year sovereign bond yield fell by 6 basis points to 2.91%, while in the United Kingdom the ten-year sovereign bond yield fell by 22 basis points to 1.28%. Intra-period movements and the overall decline in global long-term yields were driven by heightened geopolitical uncertainty and a number of worse-than-expected macroeconomic data releases.

Euro area sovereign bond spreads relative to the risk-free OIS rate remained broadly unchanged compared with September, despite some volatility. Sovereign bond market conditions were largely stable throughout the review period, with the exception of the Italian market, where ten-year spreads increased by 26 basis points to stand at 2.28% amid sustained political uncertainty (see Chart 5). Overall, since 13 September the spreads of other euro area sovereign bonds have been broadly unchanged and, consequently, the GDP-weighted average of ten-year sovereign bond yields has remained stable, standing at 37 basis points on 5 December.

The euro overnight index average (EONIA) was -36 basis points on average over the review period. Excess liquidity decreased slightly, falling by about €13 billion to stand at around €1,891 billion. The decline in excess liquidity was driven by an increase in net autonomous factors, the maturing of the first series of targeted longer-term refinancing operations (TLTRO-I) and some early repayments of funds borrowed under the second series (TLTRO-II). At the same time, ongoing purchases under the Eurosystem’s asset purchase programme partially offset the decline in excess liquidity. For further details on developments in liquidity conditions, see Box 2.

The EONIA forward curve shifted downwards somewhat over the review period. The curve remains below zero for horizons prior to 2021, reflecting market expectations of a prolonged period of negative interest rates (see Chart 6).

Broad indices of euro area equity prices fell amid increasing geopolitical uncertainty and some spillover from volatility in US markets. Over the review period equity prices of euro area banks and non-financial corporations (NFCs) decreased by around 13% and 9% respectively (see Chart 7). Falls of similar magnitudes were observed in the United States. Some of the fall in euro area equity prices was driven by downward revisions to corporate earnings expectations in the light of a perceived deterioration in the macroeconomic outlook. However, overall, earnings expectations remain above average for euro area corporations and supportive of their equity prices. Euro area equity market volatility increased over the review period amid ongoing tension in euro area sovereign bond markets, geopolitical uncertainty and some spillover from volatility in US equity markets.

Euro area corporate bond spreads increased over the review period. Since September the spread on investment-grade NFC bonds relative to the risk-free rate has increased by around 30 basis points to stand at 96 basis points (see Chart 8). Yields on financial sector debt have also increased, resulting in a widening of the spread of around 35 basis points. Model-based estimates suggest that this increase most likely reflects a repricing of risk rather than an increase in default probabilities. Overall, corporate bond spreads remain below the levels observed in March 2016, prior to the announcement and subsequent launch of the corporate sector purchase programme.

In foreign exchange markets, the euro broadly weakened in trade-weighted terms (see Chart 9). Over the review period the nominal effective exchange rate of the euro, measured against the currencies of 38 of the euro area’s most important trading partners, depreciated by 1.7%. In bilateral terms, the euro weakened against most currencies. In particular, it depreciated against the US dollar by 2.4%, partly reflecting expectations about the relative future monetary policy stances of the Federal Reserve System and the ECB. The euro also broadly depreciated vis-à-vis the currencies of most emerging economies, including the Chinese renminbi (by 1.7%) and, in particular, the Turkish lira (by 15.5%), the Brazilian real (by 9.0%) and the Russian rouble (by 5.3%), which continued to make up some of their previous losses.

Economic activity

Euro area real GDP growth slowed further to 0.2%, quarter on quarter, in the third quarter of 2018, mainly as a result of sector-specific developments. Looking ahead, the incoming information remains overall consistent with an ongoing economic expansion, albeit with increased downside risks. Euro area real GDP growth is supported primarily by growth in private consumption and investment. The December 2018 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 1.7% in 2019, 1.7% in 2020 and 1.5% in 2021. Compared with the September 2018 projections, real GDP growth has been revised down slightly for 2018 and 2019, mainly owing to the weaker data outturn in the third quarter of 2018 and the associated lower carry-over into 2019.

Growth in the euro area moderated further in the third quarter of 2018, mainly owing to sector-specific developments, but remained resilient overall, despite a slight contraction in a few euro area countries. Real GDP increased by 0.2%, quarter on quarter, in the third quarter of this year, following growth of 0.4% in the previous two quarters (see Chart 10). The slowdown in the third quarter appears to have been mainly related to temporary bottlenecks in car production (mainly in Germany). For a more detailed discussion of the slowdown in growth in 2018, see Box 3. Domestic demand continued to make a positive contribution to growth in the third quarter of 2018, although it was smaller than in previous quarters. Changes in inventories also provided a further positive contribution, whereas net trade made a negative contribution. On the production side, economic activity in the third quarter was again mainly supported by robust growth in the services and construction sectors, while value added in industry (excluding construction) contracted somewhat.

Employment continued to increase in the third quarter of the year, rising by 0.2%, quarter on quarter (see Chart 11). The level of employment currently stands 2.6% above the pre-crisis peak recorded in the first quarter of 2008. Employment increased in most euro area countries and the increase was also broadly based across sectors. With the latest increase, cumulative employment growth in the euro area since the trough in the second quarter of 2013 amounts to 9.6 million. While this increase is similar in magnitude to that seen in the five years before the crisis, its composition differs, particularly in terms of contributions by age group (see Box 4). Continuing employment growth in combination with the drop in GDP growth in 2018 has translated into a moderation in productivity growth, following a modest pick-up in 2017.

Short-term labour market indicators have been weaker recently, but still point to continuing employment growth in the fourth quarter of 2018. The euro area unemployment rate stood at 8.1% in October, unchanged from the third quarter of 2018, and remains at the lowest level seen since November 2008. Survey indicators have moderated somewhat from very high levels, but still point to continued employment growth in the fourth quarter of 2018. While indicators of labour shortages have moderated slightly in some sectors and countries, they remain at historically very high levels.

Despite some short-term weakness, private consumption continues to be driven by employment growth and stronger household balance sheets. Private consumption rose by 0.1%, quarter on quarter, in the third quarter of 2018, following somewhat stronger growth in the second quarter. Retail trade displayed zero growth in the third quarter of 2018. Moreover, new passenger car registrations in October were more than 16% below the level recorded in the third quarter. However, these data are currently difficult to interpret owing to the temporary bottlenecks in car production and sales. While crude oil prices are still far below the peaks recorded in 2012, they have been volatile recently, giving rise to heightened uncertainty about households’ purchasing power. From a longer-term perspective, increasing labour income continues to support the solid underlying momentum in consumer spending. In addition, the strengthening of households’ balance sheets remains an important factor behind steady consumption growth, particularly as households’ creditworthiness is a key determinant of their access to credit.

The ongoing recovery in housing markets is expected to continue to drive growth, albeit at a slower pace. Housing investment increased by 0.6% in the third quarter of 2018, reflecting the continuing recovery in many euro area countries and in the euro area as a whole. Recent short-term indicators and survey results point to positive, but decelerating, momentum. Construction production in the buildings segment increased by 0.8%, quarter on quarter, in the third quarter of 2018, decelerating from 0.9% in the second quarter. The European Commission’s construction confidence indicators in the last few months point to positive, albeit weakening, momentum in the fourth quarter of 2018. The Purchasing Managers’ Index (PMI) for housing activity averaged 50.1 from September to November. Confidence indicators from European Commission surveys also declined somewhat in November. However, both the PMI indicators and the European Commission confidence indicators remain clearly above their long-run averages.

Business investment (proxied by non-construction investment) rose by 0.4%, quarter on quarter, in the third quarter of 2018, following the strong rebound in the previous quarter (1.7%). The slowdown was entirely due to the marked deceleration in the quarterly growth of the machinery and equipment component, which fell from 2.5% in the second quarter of 2018 to 0.5% in the third quarter. This was partly explained by the rather weak export performance, given that this component is highly trade-intensive. Developments across countries also exhibited some disparities. While non-construction investment increased at robust growth rates in France and Spain (1.9% and 1.5%, quarter on quarter, respectively), it grew more moderately in Germany and the Netherlands (0.6% and 0.3%, quarter on quarter, respectively), and in Italy it declined sharply (-2.3%, quarter on quarter). Despite these recent developments, business investment is expected to remain supported by resilient domestic demand, profitability and favourable financial conditions in the period ahead. However, trade policy uncertainty and weakening global trade are factors that pose downside risks.

After the recovery in the second quarter, total real euro area exports slightly contracted in the third quarter of 2018 in quarter-on-quarter terms. The decline in exports was driven by goods exports (-0.2%), whereas services exports slightly increased (0.2%). Data on trade in goods show that the weakness in goods exports primarily resulted from intra-euro area export flows. Extra-euro area export growth improved, but remained subdued, particularly exports to the United Kingdom, China and Turkey. Total real euro area imports increased by 0.6%, quarter on quarter, in the third quarter of 2018. This led to a negative net trade contribution of 0.3 percentage point. Looking ahead, leading indicators confirm weak export performance in the near future, with survey results pointing to a small contraction in exports and hard data based on industrial orders outside the euro area pointing to a less pronounced deterioration.

The latest economic indicators and survey results, while somewhat weaker than expected, overall confirm ongoing broad-based growth of the euro area economy. Industrial production (excluding construction) increased slightly in October. However, outcomes were mixed across sectors and across the larger euro area countries. The European Commission’s Economic Sentiment Indicator (ESI) declined in October and remained broadly stable in November, but remains well above its long-term average. The composite output PMI decreased in October and November, while still remaining at levels suggesting continued growth.

The ongoing broad-based economic expansion is expected to continue. The ECB’s accommodative monetary policy continues to support domestic demand. Ongoing employment gains and rising wages should underpin private consumption. At the same time, business investment is supported by solid domestic demand, favourable financing conditions and improving balance sheets. Residential investment remains buoyant.

The December 2018 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 1.7% in 2019, 1.7% in 2020 and 1.5% in 2021 (see Chart 12). Compared with the September 2018 projections, real GDP growth has been revised down slightly for 2018 and 2019. This reflects the weaker data outturn in the third quarter of 2018 and the associated lower carry-over into 2019. At the same time, for both 2019 and 2020, while slightly higher long-term lending rates, lower stock prices and lower foreign demand growth will dampen activity, these effects are expected to be broadly offset by the favourable impact of lower oil prices, the weaker effective exchange rate of the euro and some additional fiscal loosening. The risks surrounding the euro area growth outlook can still be assessed as broadly balanced. However, the balance of risks is moving to the downside owing to the persistence of uncertainties related to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility.

Prices and costs

According to Eurostat’s flash estimate, euro area annual HICP inflation declined to 2.0% in November 2018, from 2.2% in October. While measures of underlying inflation continued to move sideways, domestic cost pressures continued to strengthen and broaden amid high levels of capacity utilisation and tightening labour markets. Looking ahead, underlying inflation is expected to increase gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion and rising wage growth. This assessment is also broadly reflected in the December 2018 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.6% in 2019, 1.7% in 2020 and 1.8% in 2021 – revised downwards slightly for 2019 from the September 2018 ECB staff macroeconomic projections. Annual HICP inflation excluding energy and food is expected to be 1.4% in 2019, 1.6% in 2020 and 1.8% in 2021.

Headline inflation decreased in November. According to Eurostat’s flash estimate, euro area annual HICP inflation declined to 2.0% in November 2018, from 2.2% in October (see Chart 13). This reflected lower inflation rates for all main sub-components: energy, HICP inflation excluding energy and food (HICPX), and total food. The contribution of energy prices to headline inflation is likely to continue declining strongly as the impact of past higher oil prices fades.

Measures of underlying inflation continued their recent sideways movement after rising from earlier lows. HICP inflation excluding energy and food was 1.0% in November, down from 1.1% in October, and thus continued to hover around the 1% rate it reached after rising from its low in mid-2016. The decrease in November reflected a decline in services inflation from 1.5% to 1.3%, while non-energy industrial goods inflation remained unchanged at 0.4%. Other measures of underlying inflation, including the Persistent and Common Component of Inflation (PCCI) and the Supercore,^[1] which are only available for the period to October, generally also pointed to a continuation of the broad sideways movement of recent months (see Chart 14). Looking ahead, measures of underlying inflation are expected to increase gradually, driven by a further strengthening of compensation per employee and output prices coupled with lagged indirect effects from earlier higher oil prices.

Price pressures for non-energy industrial goods in the HICP were largely unchanged in the later stages of the supply chain. There were mixed signals in the recent data for the very early stages of the pricing chain: the annual rate of change of oil prices in euro fell modestly in October and then substantially in November. In contrast, global non-energy producer price inflation was 4.6% in October, up considerably from its historical average of about 2.5% at the beginning of this year. Despite stabilising in recent months at about 0.8%, import price inflation for non-food consumer goods and for intermediate goods remained substantially higher than their lows recorded earlier this year (see Chart 15). Domestic producer price inflation for non-food consumer goods increased slightly to 0.8% in October, up from 0.7% in the previous three months and above its long-term average of 0.6%. Overall, price pressures along the later stages of the supply chain remained broadly unchanged.

Recent developments in wage growth signal a continued upward trend and support the notion of a gradual build-up in domestic cost pressures. Annual growth in compensation per employee increased to 2.5% in the third quarter of 2018, compared with 2.2% in the second quarter of 2018. Compensation per employee growth now stands markedly higher than in the first half of 2016. These developments are in line with increasing tightness in the labour market. Also, factors that were weighing on wage growth, including past low inflation and the ongoing impact of labour market reforms implemented in some countries during the crisis, continue to fade. While the early phase of strengthening compensation per employee growth was driven mainly by the wage drift, most of the momentum in recent quarters came from the rise in the annual growth of negotiated wages (see the box entitled “Recent developments in the wage drift in the euro area” in this issue of the Economic Bulletin). Together with the broadening of wage growth across sectors (see Chart 16), this has bolstered confidence in the wage growth outlook.

Market-based measures of longer-term inflation expectations have fallen somewhat, while survey-based measures have remained stable. The five-year forward inflation-linked swap rate five years ahead stood at 1.62% on 6 December 2018, around 7 basis points lower than the level which prevailed in mid-September (see Chart 17). The forward profile of market-based measures of inflation expectations continues to point towards a prolonged period of low inflation with a gradual return to inflation levels below, but close to, 2%.The risk-neutral probability of negative average inflation over the next five years implied by inflation options markets is negligible, which suggests that markets currently consider the risk of deflation to be very low. According to the ECB Survey of Professional Forecasters for the fourth quarter of 2018, longer-term inflation expectations have remained stable at 1.9%.

The December 2018 Eurosystem staff macroeconomic projections expect underlying inflation to increase gradually over the projection horizon. On the basis of the information available at mid-November, these projections expect headline HICP inflation to average 1.6% in 2019, 1.7% in 2020 and 1.8% in 2021, representing a downward revision of 0.1 percentage point in 2019 from the September 2018 ECB staff macroeconomic projections (see Chart 18). This pattern reflects a sharp decline in HICP energy inflation from its current high rates during the course of 2019, as the impact of strong past increases in oil prices fades, while HICP inflation excluding energy and food is expected to rise in line with the anticipated widening of the positive output gap and tightening labour market conditions. HICP inflation excluding energy and food is expected to rise from 1.4% in 2019 to 1.6% in 2020 and 1.8% in 2021.

Money and credit

In October 2018 broad money growth picked up amid an ongoing shift towards more self-sustained sources of money creation as the monthly net asset purchases under the asset purchase programme (APP) are reduced. Lending to the private sector continued to grow and remained the largest driver of broad money growth, albeit with some signs of slowing down, mainly for loans to non-financial corporations (NFCs). At the same time, bank funding and lending conditions remained very favourable. In addition, the net issuance of debt securities by NFCs strengthened considerably in the third quarter of 2018, benefiting from bond market conditions that were still relatively favourable.

Broad money growth picked up in October, but remained below the level it had maintained until late 2017. The annual growth rate of M3 increased to 3.9% in October 2018 from 3.5% in September (see Chart 19). This development in part reflected a sizeable monthly flow and a base effect. Since late 2017, M3 growth has eased as the reduction in net asset purchases (from €80 billion to €60 billion in April 2017, to €30 billion in January 2018, and then to €15 billion in October 2018) meant that the APP had a smaller positive impact on M3 growth.^[2] The narrow money aggregate M1, which includes the most liquid components of M3, continued to make a significant contribution to broad money growth, remaining stable at 6.8% in October. Money growth continued to receive support from sustained economic expansion and the low opportunity cost of holding the most liquid instruments in an environment of very low interest rates.

Overnight deposits remained the main contributor to M3 growth. The annual growth rate of overnight deposits remained at 7.3% in October, reflecting the steady expansion of overnight deposits held by households, while the annual growth of overnight deposits held by NFCs moderated. Currency in circulation grew steadily, thereby not pointing to any large-scale substitution of cash for deposits in an environment of very low or negative interest rates. Short-term deposits other than overnight deposits (i.e. M2 minus M1) continued to make a negative contribution to M3 growth, although the spread between the interest rates on short-term time deposits and overnight deposits has stabilised since late 2017. Marketable instruments (i.e. M3 minus M2), which are a small component of M3, also had a negative impact on M3 growth, given the currently low remuneration of these instruments.

Credit to the private sector is the largest driver of broad money growth (see Chart 20). From a counterpart perspective, the positive contribution to M3 growth from general government securities held by the Eurosystem decreased further (see the red parts of the bars in Chart 20) in the context of the aforementioned reduction in monthly net purchases under the APP. This has been largely offset by a moderate increase in the contribution from credit to the private sector since late 2017 (see the blue parts of the bars in Chart 20). This marks an ongoing shift towards more self-sustained sources of money creation, with credit to the private sector surpassing Eurosystem purchases of general government debt securities as the largest contributor to M3 growth in October. By contrast, government bond sales by euro area monetary financial institutions (MFIs) excluding the Eurosystem dampened M3 growth (see the light green parts of the bars in Chart 20). Finally, for the first time since June 2015 the contribution from net external assets (see the yellow parts of the bars in Chart 20), which among other things reflects investors’ preferences for euro area assets, turned positive in October.

The increase in the growth of loans to the private sector observed since the beginning of 2014 paused in October. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) declined slightly to 3.3% in October, compared with 3.4% in September (see Chart 19). From a sectoral perspective, the annual growth rate of loans to NFCs moderated to 3.9% in October, down from 4.3% in September. This was in line with historical patterns of lagging co-movement with economic activity and remained heterogeneous across countries (see Chart 21). The annual growth rate of loans to households remained unchanged at 3.2% in October in a context of pronounced cross-country heterogeneity (see Chart 22). Lending to the private sector is supported by very favourable financing conditions, robust growth in business investment, improvements in labour markets, mature housing markets and growth in both residential investment and private consumption. In addition, banks have made progress on consolidating their balance sheets, improving profitability and reducing non-performing loans, although the level of such loans has remained high in some countries.

Banks’ funding conditions tightened somewhat, but remained favourable. In October the composite cost of debt financing for euro area banks increased slightly, continuing the pattern seen since the beginning of 2018 (see Chart 23). This development reflected higher bank bond yields – which have also become more heterogeneous across countries – against a background of increased political uncertainty. At the same time, the costs of deposit funding have remained broadly unchanged. The repercussions of the increase in the cost of funding through the issuance of debt securities for the overall composite cost of funding for banks have been rather contained, owing to the limited share of this type of funding in banks’ funding structures. Overall, therefore, bank funding conditions have remained favourable, reflecting the ECB’s accommodative monetary policy stance and the strengthening of banks’ balance sheets.

Bank lending rates for NFCs and households remained close to their historical lows. The composite bank lending rate for NFCs (see Chart 24) remained broadly stable at 1.64% in October, close to the historical low of 1.62% seen in May 2018. Composite bank lending rates for loans to households for house purchase (see Chart 25) remained broadly unchanged at 1.80%, only slightly above the historical low of 1.78% observed in December 2016. In October 2018, the spread continued to narrow between the interest rates charged on very small loans (loans of up to €0.25 million, which are a proxy for loans to small firms) and those charged on large loans (loans of above €1 million, which are a proxy for loans to large firms). Moreover, between May 2014 and October 2018 composite lending rates on loans to NFCs and households fell by around 130 and 110 basis points respectively. The reduction in bank lending rates on NFC loans was particularly strong in those euro area countries most affected by the financial crisis. Overall, therefore, since the announcement of the ECB’s credit easing measures in June 2014, the transmission of monetary policy has been restored and has become more homogenous across countries and firm sizes.

The annual flow of total external financing to euro area NFCs is estimated to have increased further in the third quarter of 2018. This development, which was broad-based across instruments, reflects a further strengthening of bank lending dynamics, supported inter alia by the continued easing of credit standards and a decline in the relative cost of bank lending. Overall, the recovery in NFCs’ external financing since early 2014 has been supported by the pass-through of the monetary policy measures put in place, improving borrowing conditions and financing requirements related to the higher number of mergers and acquisitions. At the same time, NFCs’ high retained earnings have reduced the need for external financing.

In the third quarter of 2018 the net issuance of debt securities by NFCs strengthened considerably, benefiting from bond market conditions that are still relatively favourable. Issuance activity picked up in September after having been virtually flat over the first two months of the quarter. In terms of annual flows (see Chart 26), the net issuance of debt securities rebounded in September from a two-year low in August, while the net issuance of quoted shares stabilised around the high levels recorded in 2015-16. Market data suggest that the net issuance of debt securities moderated in October and November 2018. The net issuance of listed shares was marginally negative in the third quarter of 2018, possibly owing to the increase in the cost of equity financing.

For NFCs, the cost of financing has edged up marginally to stabilise at levels close to those recorded at the beginning of the year. In October the overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, stood at 4.7%, which was only marginally higher than in September. In November the cost of financing is estimated to have remained virtually constant. The current cost of external financing surpasses the historical low of August 2016 by around 48 basis points and remains substantially lower than the level seen in mid-2014, when market expectations regarding the introduction of the public sector purchase programme began to emerge.

Fiscal developments

The euro area general government budget deficit is projected to have declined significantly in 2018 but to increase somewhat next year. The fall in 2018 was mainly the result of favourable cyclical conditions and declining interest payments. The aggregate fiscal stance for the euro area is expected to be broadly neutral in 2018, to loosen in 2019 and 2020, and to turn neutral again in 2021. However, these fluctuations in the aggregate stance for the euro area mask significant differences across countries. For instance, in 2018 large windfalls in a few countries have compensated in the aggregate for procyclical fiscal loosening in vulnerable countries. In particular the countries with high debt levels would, on the contrary, benefit from additional consolidation efforts to set their public debt ratio firmly on a downward path.

The euro area general government budget deficit is projected to have declined significantly in 2018 but to increase somewhat next year. Based on the December 2018 Eurosystem staff macroeconomic projections,^[3] the general government deficit ratio for the euro area is expected to fall from 1.0% of GDP in 2017^[4] to 0.6% of GDP in 2021, with a temporary worsening in 2019. The overall improvement in the fiscal outlook is mainly driven by lower interest payments and favourable cyclical developments. This is partly offset by a lower cyclically adjusted primary balance from 2019 onwards (see Chart 27).

The outlook for the euro area general government deficit for the next two years has deteriorated compared with the September 2018 ECB staff projections. The higher deficit is partly the outcome of a significant worsening of the projected budgetary balance in Italy due to the fiscal expansion included in the draft budgetary plan, which would be in breach of the commitments under the Stability and Growth Pact (SGP). For the euro area, this deterioration is reflected in a somewhat higher primary expenditure and a lower cyclical component.

The aggregate fiscal stance for the euro area is expected to be broadly neutral in 2018, to loosen in 2019 and then to gradually return to neutral in 2021. ^[5] This profile is affected by discretionary measures which are projected to be expansionary both in 2018 and over the next two years. However, in 2018 large revenue windfalls due to buoyant direct tax collection in a few countries are expected to have more than compensated for this.

The decline in the euro area aggregate public debt-to-GDP ratio is projected to continue. According to the December 2018 Eurosystem staff macroeconomic projections, the aggregate general government debt-to-GDP ratio in the euro area is expected to decline from 86.8% of GDP in 2017^[6] to 79.0% of GDP in 2021. The projected reduction in government debt is supported by both the negative interest rate-growth rate differential and primary surpluses (see Chart 28). Deficit-debt adjustments are expected to offset some of these effects. Over the projection horizon, the debt ratio should fall or broadly stabilise in all euro area countries but will continue to far exceed the reference value of 60% of GDP in a number of countries. Compared with the September 2018 projections, the decline in the aggregate euro area debt-to-GDP ratio is expected to be marginally more subdued due to a lower primary surplus path.

Countries need to continue their fiscal efforts in full compliance with the SGP. For high debt countries in particular, further consolidation efforts are essential to set the public debt ratio firmly on a downward path, as their high debt levels render them vulnerable to any future downturns or renewed financial market instability. In the light of this, it is of concern that compliance with the SGP is weakest for those countries that are most vulnerable to shocks. In fact, according to the European Commission’s projections, most of the countries that have not yet reached sound budgetary positions missed their commitments under the SGP in 2018 and are at risk of doing so again in 2019.^[7] It is particularly worrying that the largest deviation from existing commitments is in Italy, a country with a markedly high debt ratio.

Boxes

Emerging market vulnerabilities – a comparison with previous crises

Prepared by Livia Chiṭu and Dominic Quint

Against the background of financial market volatility in some emerging market economies (EMEs) since April, this box reviews key vulnerabilities in EMEs. Specifically, it assesses their resilience to external shocks compared to previous crisis episodes.

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Liquidity conditions and monetary policy operations in the period from 1 August to 30 October 2018

Prepared by Mª Carmen Castillo Lozoya and Elvira Fioretto

This box describes the ECB’s monetary policy operations during the fifth and sixth reserve maintenance periods of 2018, which ran from 1 August to 18 September 2018 and from 19 September to 30 October 2018 respectively. Throughout this period the interest rates on the main refinancing operations (MROs), the marginal lending facility and the deposit facility remained unchanged at 0.00%, 0.25% and −0.40% respectively. In parallel, the Eurosystem continued to purchase public sector securities, covered bonds, asset-backed securities and corporate sector securities as part of its asset purchase programme (APP), with a target of €30 billion of purchases on average per month until the end of September and €15 billion as of October.

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Understanding the slowdown in growth in 2018

Prepared by Maarten Dossche and Jaime Martinez-Martin

Growth in economic activity has moderated significantly in the euro area since the end of 2017. Indeed, quarter-on-quarter GDP growth in the euro area fell to 0.2% in the third quarter of 2018, down from 0.7% in the fourth quarter of 2017. This box assesses the factors which are contributing to that slowdown and looks at whether it should be considered a surprise. In particular, it looks at whether the underlying factors are temporary or of a more permanent nature, whether they have originated within the euro area or externally, and whether the slowdown has been driven by a weakness in demand or a tightening of supply conditions.

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Compositional changes behind the growth in euro area employment during the recovery

Prepared by Katalin Bodnár

In the third quarter of 2018 the total number of people in employment in the euro area was 9.6 million higher than in the second quarter of 2013 (when it fell to its lowest point during the crisis). The increase in employment over the course of the recovery has more than offset the decline observed during the crisis. As a result, euro area employment is currently at its highest level ever, standing at 158.3 million.^[8] This box describes the net employment growth in the euro area over the course of the recovery and compares it to the period from the first quarter of 1999 to the first quarter of 2008 (i.e. from the introduction of the euro to the start of the crisis), which was also characterised by a continuous increase in employment across the euro area as a whole.

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Recent developments in the wage drift in the euro area

Prepared by Gerrit Koester and Justine Guillochon

The wage drift measures deviations between developments in actual wages and developments in negotiated wages. It is an important element in the macroeconomic analysis of employee compensation because it should be closely linked to cyclical developments in the labour market. In a tightening labour market, employers might be compelled to offer pay scales that are higher than those under collective agreements, to promote employees to higher bands within collectively agreed pay scales, or simply to pay bonuses on top of agreed wages as a way to reward and retain employees. Given recent protracted declines in unemployment and increasing signs of labour shortages, this box reviews the role of the wage drift in recent developments in employee compensation.

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An assessment of draft budgetary plans for 2019

Prepared by Stephan Haroutunian, Sebastian Hauptmeier and Nadine Leiner-Killinger

On 21 November 2018 the European Commission released its opinions on the draft budgetary plans (DBPs) of euro area governments for 2019, together with an analysis of the budgetary situation in the euro area as a whole. Each opinion includes an assessment of the compliance of the relevant plan with the Stability and Growth Pact (SGP). This exercise is important as it assesses whether countries have incorporated into their plans the country-specific recommendations for fiscal policies that were addressed to them under the 2018 European Semester, as adopted by the Economic and Financial Affairs Council on 13 July 2018.^[9] These recommendations propose, among other things, that countries with high ratios of government debt to GDP aim for a sufficiently fast reduction in indebtedness. This would raise their resilience in a future economic downturn.^[10]

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Statistics

Statistical annex