Economic and monetary developments

Overview

At its monetary policy meeting on 8 June 2017, the Governing Council concluded that a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term. The information that has become available since the previous monetary policy meeting in late April confirms a stronger momentum in the euro area economy, which is projected to expand at a somewhat faster pace than previously expected. The Governing Council considers that the risks to the growth outlook are now broadly balanced. Against this background, very adverse scenarios for the outlook for price stability have become increasingly unlikely to materialise, in particular as deflation risks have largely vanished. Hence, the Governing Council decided to drop the reference to lower interest rates from its forward guidance on policy rates. At the same time, the economic expansion has yet to translate into stronger inflation dynamics. So far, measures of underlying inflation continue to remain subdued and have yet to show a convincing upward trend. Therefore, the very substantial degree of monetary accommodation remains appropriate.

Economic and monetary assessment at the time of the Governing Council meeting of 8 June 2017

The ECB’s monetary policy measures have continued to preserve the very favourable financing conditions that are necessary to secure a sustained convergence of inflation rates towards levels below, but close to, 2% over the medium term. This is evident in continued very low bank interest rates. Likewise, 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, notably for small and medium-sized enterprises, and, hence, credit flows across the euro area. Broad money continues to expand at a robust pace, while the recovery in loan growth to the private sector observed since the beginning of 2014 is proceeding.

The ongoing economic expansion in the euro area is increasingly resilient and has broadened across sectors and countries. Euro area real GDP increased by 0.6%, quarter on quarter, in the first quarter of 2017, after 0.5% in the last quarter of 2016. Short-term indicators such as surveys continue to point to robust growth momentum in the near term. The pass-through of the ECB’s monetary policy measures has also facilitated the deleveraging process and should continue to support domestic demand. In particular, the recovery in investment continues to benefit from very favourable financing conditions and improvements in corporate profitability. Employment gains, which are also benefiting from past labour market reforms, are supporting real disposable income and private consumption.

Euro area activity is further supported by a sustained global recovery. Global trade growth has increased significantly in recent months, benefiting from, among other factors, the recoveries in emerging market economies. However, euro area economic growth prospects continue to be dampened by a sluggish pace of implementation of structural reforms, in particular in product markets, and by remaining balance sheet adjustment needs in a number of sectors, notwithstanding ongoing improvements.

The June 2017 Eurosystem staff macroeconomic projections for the euro area, finalised in late May, which are conditional on the full implementation of all ECB monetary policy measures, foresee annual real GDP increasing by 1.9% in 2017, by 1.8% in 2018 and by 1.7% in 2019. Compared with the March 2017 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised upwards over the projection horizon. The risks surrounding the euro area growth outlook are considered to be broadly balanced. On the one hand, the current positive cyclical momentum increases the chances of a stronger than expected economic upswing. On the other hand, downside risks relating to predominantly global factors continue to exist.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 1.4% in May, following 1.9% in April and 1.5% in March. As expected, the recent volatility in inflation rates was mainly due to energy prices and temporary increases in services prices over the Easter period. Following the recent fall in oil prices, global headline inflation has stabilised. Looking ahead, on the basis of current futures prices for oil, headline inflation in the euro area is likely to remain around recent levels in the coming months.

Measures of underlying inflation have remained low and have yet to show convincing signs of a pick-up, as unutilised resources are still weighing on domestic price and wage formation. Underlying inflation is expected to rise only gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion and the corresponding gradual absorption of economic slack.

The June 2017 Eurosystem staff macroeconomic projections for the euro area foresee annual HICP inflation at 1.5% in 2017, 1.3% in 2018 and 1.6% in 2019. By comparison with the March 2017 ECB staff macroeconomic projections, the outlook for headline HICP inflation has been revised downwards, mainly reflecting lower oil prices.

The euro area budget deficit is projected to fall further over the projection horizon (2017-19), mainly as a result of improving cyclical conditions and decreasing interest payments. The aggregate fiscal stance for the euro area is projected to be broadly neutral over the period 2017-19. The euro area government debt-to-GDP ratio, although still high, is projected to continue to decline. Countries with high levels of public debt would benefit from additional consolidation efforts to set their debt-to-GDP ratio firmly on a downward path.

Monetary policy decisions

Based on the regular economic and monetary analyses, the Governing Council confirmed the need for a continued very substantial degree of monetary accommodation to secure a sustained return of inflation rates towards levels that are below, but close to, 2%. The Governing Council decided to keep the key ECB interest rates unchanged and expects them to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases. Regarding non-standard monetary policy measures, the Governing Council confirmed that the net asset purchases under the asset purchase programme (APP), at the current monthly pace of €60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. The net purchases will be made alongside reinvestments of the principal payments from maturing securities purchased under the APP. Moreover, the Governing Council confirmed that if the outlook became less favourable, or if financial conditions became inconsistent with further progress towards a sustained adjustment in the path of inflation, it would stand ready to increase the APP in terms of size and/or duration.

External environment

A temporary dip in global GDP growth in the first quarter of 2017 notwithstanding, global activity growth remained sustained in the first months of the year. Momentum in global trade improved markedly, driven mostly by increased trade from emerging market economies. Global headline inflation has stabilised in recent months, as the effect of past commodity price increases has diminished. However, oil prices have declined in recent weeks, which should dampen global inflation rates in the short term.

Global economic activity and trade

A temporary dip in global GDP growth in the first quarter of 2017 notwithstanding, global activity growth remained sustained at the start of year. In the United States, GDP growth fell to 0.3% quarter-on-quarter, mainly reflecting weaker consumer spending and a large reduction in inventory investment spending. In the United Kingdom, GDP growth also declined, as higher inflation following the depreciation of the pound sterling squeezed real incomes and household spending. In China, the decline in GDP growth to 1.3% quarter-on-quarter was somewhat at odds with more upbeat short-term indicators. On the other hand, GDP growth rebounded sharply in both Russia and Brazil as they exited recession, while, in India, activity growth recovered amid the waning effects of demonetisation.

Survey indicators suggest that global growth will rebound in the near term. Excluding the euro area, the global composite Purchasing Managers’ Index (PMI) was largely unchanged in May, remaining slightly below the long-run average level and signalling a continued moderate expansion in global activity (Chart 1). Sentiment surveys have been upbeat, with consumer confidence in OECD countries rising towards pre-crisis levels and business confidence also improving.

Financial markets are consistent with expectations of improving near-term global growth. Having risen sharply after the US election, global equity markets and long-term bond yields declined in April and early May amid investor doubts about the ability of the new US administration to follow through on policy promises. However, global markets rebounded sharply after the French presidential election. Overall, financial markets have generally been resilient and risk aversion low. Financial conditions in emerging market economies (EMEs) are also benefitting from expectations of a brighter global growth outlook and capital flows towards EMEs have revived.

Monetary policies remain accommodative. While other major central banks are expected to maintain their accommodative stance, markets continue to expect monetary tightening in the United States to be very gradual. In China, financial conditions have tightened as the People’s Bank of China increased interbank rates in an effort to curb the riskier lending of small banks and non-bank institutions. However, benchmark bank lending rates for non-financial firms have remained unchanged, suggesting that, so far, the impact on the broader economy is modest.

Looking ahead, after a rebound in the near term, global economic activity is expected to accelerate gradually. The outlook among advanced economies entails a modest expansion, underpinned by continued monetary and fiscal policy support, as the cyclical recovery continues and output gaps gradually close. Among EMEs, the outlook is supported by resilient growth in China and India, while activity is expected to strengthen among commodity exporters. The recovery of these latter economies is the main driver of the projected increase in global GDP growth in the next two years. Nonetheless, the pace of global expansion will remain below pre-crisis rates, which is consistent with estimates suggesting that the growth potential has declined across most advanced and emerging economies in recent years.

In the United States, activity is expected to strengthen. After the weak first quarter, a strong rebound is expected in the remainder of 2017, as consumer and business sentiment remain high and improved labour market conditions gradually feed into higher wage growth. A strong recovery in investment in the energy sector is also expected to support the economy.

In the United Kingdom, real GDP growth is expected to remain relatively muted in the near term. Although the depreciation of the pound sterling is likely to support exports, the increase in inflation is expected to weigh on household incomes and private consumption. Heightened uncertainty about the United Kingdom’s future trade arrangements are also anticipated to weigh on investment.

In Japan, accommodative policies are expected to continue to support expansion. Accommodative monetary policy, looser financial conditions and the fiscal stimulus programme should support domestic demand, while exports are expected to gradually recover as external demand improves. However, despite robust job creation, wage increases have remained modest, dampening private consumption.

In China, activity is expected to continue expanding at a robust pace, supported by resilient consumption and the buoyant housing market. However, an increased focus on containing financial stability risks has led to tighter financial conditions since late 2016. In the medium term, growth is anticipated to remain on a gradual downward trend, consistent with the authorities’ desire to rebalance the economy.

Central and eastern European countries are expected to benefit from strong consumption and investment, the latter supported by EU structural funds. Although inflation is expected to gradually increase, reflecting fading effects of energy price falls, real disposable income is also expected to strengthen as the labour market tightens and wage pressures increase.

The large commodity exporters are expected to continue their recovery after deep recessions. In Russia, the rebound in the oil price since last year, coupled with a more accommodative monetary policy, is expected to support growth, although domestic demand remains fragile amid high uncertainty, low real wages and depressed confidence. Stabilising business confidence, improving terms of trade and loosening financial conditions are anticipated to benefit activity in Brazil. At the same time, recurring political uncertainties and fiscal consolidation needs continue to weigh on the medium-term outlook.

Momentum in global trade improved markedly at the end of last year and in early 2017. The volume of global goods imports increased by 1.8% quarter-on-quarter in the first quarter of 2017 (Chart 2). The recovery in global trade during the second half of 2016 and early 2017 has been driven mostly by an improvement in EMEs, with trade in emerging Asia benefiting from Chinese investment following a policy stimulus. Leading indicators point to continued robust trade prospects in the near term, with the global PMI for new export orders at 52.3 in May. Looking further ahead, while the outlook is subject to some uncertainties arising from the new US administration’s rhetoric on trade policies, world trade is expected to expand broadly in line with global activity.

Overall, global growth is projected to increase gradually over the period 2017‑19. According to the June 2017 Eurosystem staff macroeconomic projections, world real GDP growth excluding the euro area is projected to accelerate from 3.2% in 2016 to 3.5% in 2017 and 3.8% in 2018-19. Euro area foreign demand growth is expected to increase from 1.3% in 2016 to 3.7% in 2017, followed by growth of 3.4% in 2018 and 3.5% in 2019. Compared with the March 2017 projections, global GDP growth is largely unrevised, while euro area foreign demand growth has been revised upwards for 2017, reflecting stronger import data around the turn of the year.

The uncertainty surrounding the baseline projections for global activity remains elevated, with the balance of risks tilted to the downside. On the upside, there is the possibility that improved sentiment – as evidenced in surveys and financial markets – will translate into a faster-than-expected revival of activity and trade in the short term. Key downside risks include an increase in trade protectionism; a disorderly tightening of global financial conditions, which could affect vulnerable EMEs in particular; possible disruptions associated with China’s reform and liberalisation process; and the potential for volatility derived from political and geopolitical uncertainties, including those related to negotiations about future relations between the United Kingdom and the European Union. Box 1 discusses the evolution of global risks in the past year.

Global price developments

Global consumer price inflation has stabilised as the effect of past commodity price increases begins to wane. Annual consumer price inflation in the OECD area edged up to 2.4% in April, compared with 2.3% in March. Excluding food and energy, OECD annual inflation increased slightly to 1.9% in April (Chart 3).

Commodity prices have fallen recently. Brent crude oil prices have fluctuated in the range of USD 48 to USD 56 per barrel since early March. The price fluctuations reflect shifting concerns among market participants about the likely success of the OPEC strategy to curtail production, amid still high oil inventories and rising US shale production. The prolongation of the output cut for nine months, which was agreed by OPEC and 11 non-OPEC countries on 25 May 2017, was widely anticipated by markets and priced in before the meeting. Hopes raised by some participating countries that there might be agreement on an even deeper or longer cut did not materialise, which led to a renewed price drop in the aftermath of the meeting of about 6% in US dollar terms. Looking ahead, the futures curve is signalling largely unchanged oil prices over the next three years. Non-oil commodity prices have declined by about 8% since early March.

Looking ahead, after a slight moderation in the near term, global inflation is expected to rise slowly. The recent decline in oil and other commodity prices should dampen inflation rates in the short term. Thereafter, slowly diminishing spare capacity at the global level is expected to support underlying inflation, while the current oil futures curve anticipates very stable oil prices over the projection horizon, pointing to a very limited contribution from energy prices to inflation.

Financial developments

Since the Governing Council’s monetary policy meeting in March, euro area sovereign bond yields have declined slightly, with some intra-period volatility. Corporate bond spreads have declined marginally and remain below the levels observed in early March 2016, when the corporate sector purchase programme (CSPP) was announced. Broad equity prices have risen by a larger extent in the euro area than in other major economic areas. The value of the euro has appreciated in trade-weighted terms.

Long-term euro area government bond yields have decreased slightly overall since early March. During the period under review, from 9 March to 7 June 2017, the ten-year euro area overnight index swap (OIS) rate declined by around 10 basis points to 0.55%, while the GDP-weighted ten-year euro area sovereign bond yield decreased by around 25 basis points to just above 1% (see Chart 4). This decline brought to halt the period of rising nominal yields that had been ongoing in the euro area, although with some oscillations, since early October 2016. In the United States, long-term government bond yields declined more than in the euro area, but from a higher level, declining by around 45 basis points to 2.2%. The slight decline in long-term euro area interest rates since early March took place amid some volatile episodes caused by a number of factors. Long-term euro area government bond yields initially rose in the aftermath of the March Governing Council Meeting, but towards the end of March they declined, partly on account of market perceptions of increased political uncertainty in the run-up to the first round of the French presidential election. However, in the course of April, yields began to rise again amid a decline in political uncertainty and positive data releases for the euro area economy. In the remainder of the review period, long-term euro area government bond yields recorded slight declines on the back of some moderation in global inflation expectations and more negative economic surprises abroad.

Sovereign bond yields declined markedly in a number of countries, mainly on account of the declining political uncertainty since late April as well as an improving economic outlook. Across countries, the declines ranged from a few basis points to around 120 points in Greece and Portugal. Sovereign yield spreads vis-à-vis the OIS also declined overall, mostly since the second half of April (see Chart 5).

The euro overnight index average (EONIA) forward curve has shifted downwards by slightly more than 10 basis points on average across maturities since early March (see Chart 6). An initial upward movement of the curve, until around mid-March, was more than reversed in the remainder of the review period. Overall, the EONIA forward curve shifted downwards on average by 13 basis points, with a fall of around 20 basis points for maturities ranging approximately between three and five years. By contrast, forward rates declined rather marginally for maturities up to two years. The configuration of the curve on 7 June suggests that market participants continue to expect a prolonged period of negative EONIA rates until around mid-2020, with no further cuts to the deposit facility rate (DFR) being priced in.

The EONIA hovered around -35 basis points in the period under review. It reached a record low of -37.3 basis points on 5 June amid subdued trading volumes owing to national holidays in several countries. Excess liquidity increased by over €305 billion to around €1,670 billion. This increase is attributable both to the final targeted longer-term refinancing operation (TLTRO-II) and to purchases under the expanded asset purchase programme. Liquidity conditions are discussed in more detail in Box 3.

Spreads on bonds issued by non-financial corporations (NFCs) declined marginally during the period under review (see Chart 7). On 7 June investment grade NFC bond spreads (for rating classes AA, A and BBB) were on average 9 basis points lower than in early March and around 30 basis points below their levels in March 2016, when the Governing Council announced the launch of the CSPP. Spreads on non-investment grade NFC and financial sector debt (which is ineligible for purchases under the CSPP) also declined during the period under review, by 26 and 5 basis points respectively.

Euro area equity prices have increased since early March (see Chart 8), thus continuing a trend that has been in place since around mid-2016. At the end of the period under review, equity prices of euro area NFCs were around 7.5% higher than at the beginning, while prices rose by 5.5% for financial corporations. Following recent positive developments in euro area stock markets, equity prices of banks now stand around 65% higher overall than the lows recorded in the aftermath of the United Kingdom’s referendum on EU membership in June 2016 (see Chart 8). As in the case of bonds, political uncertainty also affected developments in euro area equity markets, which mostly moved sideways ahead of the outcome of the first round of the French presidential election, but then rose significantly in the aftermath. Since early March, equity prices of NFCs in the United States, the United Kingdom and Japan have also risen, but by a lesser extent than in the euro area. Equity prices of financial corporations in these three countries underperformed even more relative to the euro area than was the case for NFCs. Market expectations of equity price volatility in the euro area increased significantly ahead of the French presidential election to around 23%, but thereafter they reverted to slightly below the levels prevailing in early March, i.e. around 13%. In the United States, expectations of equity price volatility declined overall to below 9%.

In foreign exchange markets, the euro has appreciated by 2.5% in trade-weighted terms since early March (see Chart 9). In particular, the euro appreciated vis-à-vis most other major currencies, reflecting positive surprises for the euro area economy. In bilateral terms, since 9 March, the euro has strengthened by 6.3% against the US dollar, by 4.6% against the Chinese renminbi, by 1.5% against the Japanese yen and by 1.3% against the Swiss franc. The euro also appreciated vis-à-vis the currencies of most emerging economies as well as the currencies of non-euro area EU Member States, with the exception of the currencies of some central and eastern European Member States, including the Czech koruna, the Polish zloty and the Hungarian forint, against which it weakened.

Economic activity

The ongoing economic expansion is increasingly resilient and has broadened across sectors and countries. Euro area growth is supported primarily by domestic demand, although tailwinds from the external environment have increasingly lent support to the outlook. Short-term indicators, such as surveys, confirm robust growth momentum in the near term. Compared with the March 2017 ECB staff macroeconomic projections, the June 2017 Eurosystem staff macroeconomic projections have been revised upwards and foresee euro area real GDP growing by 1.9% in 2017, 1.8% in 2018 and 1.7% in 2019.

The euro area economic expansion has gained momentum and is primarily supported by domestic demand. Real GDP increased by 0.6%, quarter on quarter, in the first quarter of 2017, following growth of 0.5% in the previous quarter (Chart 10). The euro area economy has now expanded for four consecutive years and growth has become increasingly resilient as it has broadened across sectors and countries. Domestic demand remained the engine behind growth in the first quarter of 2017 and changes in inventories contributed positively, whereas net trade provided a neutral contribution. On the production side, economic activity was mainly supported by robust growth in the construction and services sectors, whereas value added in industry (excluding construction) grew at a slower pace.

The recovery is particularly visible in euro area labour markets, although there is still sizeable slack. Growth in euro area employment continued in the fourth quarter of 2016 and, as a result, employment stood 1.2% above the level recorded one year earlier. Survey data available up to May suggest further improvements in labour market conditions. Euro area unemployment has continued to decline in 2017 after having peaked at the beginning of 2013. In April the unemployment rate stood at 9.3%, the lowest reading since March 2009. The broad trend of declining unemployment rates has continued, despite continued increases in euro area labour force participation (see Chart 11), which has been buoyed in particular by rising participation among older workers. Moreover, broader measures of unemployment suggest still elevated slack in euro area labour markets, even though the gap between the headline unemployment rate and broader measures has been narrowing recently on account of modest declines in the numbers of both discouraged and underemployed workers.^[1]

Improvements in euro area labour markets have boosted households’ real disposable incomes and facilitated consumer spending. Steady labour income growth, which is the most important driver of household disposable income, in combination with a broadly stable household savings rate, has continued to benefit private consumption. Improving bank lending conditions, reinforced by the ECB’s monetary policy measures, have also remained supportive of household spending. While low interest rates affect both households’ interest earnings and their interest payments, they tend to redistribute resources from net savers to net borrowers. As the latter typically have a higher marginal propensity to consume, this redistribution should provide further support to aggregate private consumption. Consumer confidence, which rose again in May for the third consecutive month, remains well above its long-term average level, signalling strong underlying consumer spending dynamics in the near term. In addition, the increase in households’ net worth, which reflects developments in both financial and housing wealth, should also support private consumption.

The rebound in euro area housing markets is increasingly supporting growth momentum. Although the recovery in euro area housing markets has been tardier and much weaker than the recovery in overall euro area economic activity, it has recently gained momentum. This recovery, albeit from very low levels in some countries, has been supported by the strong growth in household disposable income, favourable financing conditions and an increased preference for housing investment in the context of low yields on interest-bearing assets. In addition, the adjustment processes in the housing markets in some euro area countries appear to have come to an end and confidence has risen strongly in the construction sector. A rising number of building permits (see Chart 12), increasing demand for loans for house purchase and improved bank lending conditions should continue to support the ongoing upward trend in construction investment, which is broad-based across euro area countries.

Business investment is continuing its gradual recovery. Industrial production in the investment-intensive capital goods sector grew by a modest 0.3% in the first quarter of 2017. Meanwhile, data available for most euro area countries point to a strong rise in non-construction investment. Moreover, business sentiment in the sector strengthened further on the back of very favourable production expectations, rising order books and a turnaround in selling price expectations, while capacity utilisation further increased to stand above average pre-crisis levels. According to the European Commission’s latest bi-annual industrial investment survey, the investment outlook for 2017 in the euro area has improved.

Looking ahead, the recovery in business investment is expected to continue. It will be supported by several factors, including still very favourable financing conditions, the ECB’s very accommodative monetary policy, a need to modernise the capital stock after several years of subdued investment, above-average capacity utilisation rates, and high profit mark-ups in the non-financial sector. In addition, the strong recovery in equity prices over recent years and moderate growth in debt financing have reduced the leverage ratio (debt-to-total assets) to historical lows (see the box entitled “Private sector indebtedness and deleveraging in the euro area countries” in this issue of the Economic Bulletin for an overview of the evolution of total private sector deleveraging). Some factors, however, are expected to continue to weigh on the outlook for business investment. These include expectations of weaker long-term growth potential compared to the past, rigidities in product markets and ongoing adjustment to changes in the regulatory environment. Low bank profitability and the still high level of non-performing loans on banks’ balance sheets in a number of countries continue to weigh on the intermediation capacity of banks and, in turn, on firms’ investment funding in the near term.

An improved external environment has led to a rebound in euro area export momentum. Monthly trade data up to March 2017 point to continued growth in goods exports outside the euro area, following a rather strong export outcome in the fourth quarter of 2016. This bodes well for the overall growth outlook, as export growth has increasingly been driven by stronger demand from both Europe and the rest of the world. Specifically, exports to China, the United States and Russia have increased strongly over the past three months. This is in sharp contrast to the experience over the past three years, when exports were mainly supported by trade within Europe (Chart 13), and mirrors the increasingly broad-based global recovery in trade. Surveys and new export orders with a bearing on the second quarter of 2017 point to sustained export momentum in the near term. Looking further ahead, exports are expected to expand following the rebound in global trade. However, risks to trade remain elevated, primarily relating to an increase in protectionism that has the potential to hamper global growth.

Overall, incoming data point to solid growth in the second quarter of 2017. The European Commission’s Economic Sentiment Indicator (ESI) and the composite output Purchasing Managers’ Index (PMI) displayed broad-based improvements in the first four months of the year. In May, both indicators stood at, or close to, their post-crisis peak, albeit having fallen back somewhat compared to April. The rise in the indicators in the first two months of the second quarter of 2017 mainly reflected improved expectations of future production and order book levels, and both indicators are currently above their long-term averages (see Chart 14).

The current euro area economic expansion is expected to continue, supported by the ECB’s monetary policy measures, which are being passed through to the real economy. Domestic demand is expected to be buoyed by a number of favourable factors. Very favourable financing conditions and low interest rates continue to promote a recovery in investment in the context of rising profits and lower deleveraging needs. Private consumption growth should benefit from a further improvement in labour market conditions, in part due to past labour market reforms. Tailwinds from the cyclical recovery outside the euro area, which are expected to strengthen, will support exports. However, economic growth in the euro area is expected to be dampened by the sluggish pace of implementation of structural reforms and outstanding balance sheet adjustments in a number of sectors, notwithstanding ongoing improvements.

The June 2017 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 1.9% in 2017, 1.8% in 2018 and 1.7% in 2019 (see Chart 15). Compared with the March 2017 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised upwards. The risks surrounding the euro area growth outlook are broadly balanced. On one hand, the current positive cyclical momentum increases the chances of a stronger than expected economic upswing. On the other hand, downside risks relating to predominantly global factors continue to exist (see the box entitled “The recent evolution of global risks – an assessment” in this issue of the Economic Bulletin).

Prices and costs

According to Eurostat’s flash estimate, euro area annual HICP inflation in May 2017 was 1.4%, down from 1.9% in April. Looking ahead, on the basis of current oil futures prices, headline inflation is likely to fluctuate around current levels in the coming months. Looking through recent volatility, underlying inflation has yet to show convincing signs of a pick-up and is expected to rise only gradually over the medium term. The June 2017 Eurosystem staff macroeconomic projections for the euro area foresee annual HICP inflation at 1.5% in 2017, 1.3% in 2018 and 1.6% in 2019.

Headline inflation fell in May. Recent movements in oil prices and the timing of Easter have meant that headline inflation has been quite volatile in recent months. According to Eurostat’s flash estimate, it was 1.4% in May 2017, after 1.9% in April and 1.5% in March. The decrease in May was anticipated for two main reasons. First, services price inflation fell sharply, unwinding the strong pick-up in April, owing to the impact on the year-on-year change of the different timing of Easter in 2017 compared with 2016. Second, energy price inflation declined on account of a downward base effect associated with the sharp increase in energy prices one year earlier and the additional downward pressure stemming from the drop in oil prices in recent months.

Underlying inflation has yet to show robust signs of an upward adjustment. Some measures of underlying inflation have been skewed in recent months, owing to temporary factors such as the timing of Easter and the impact of recent oil price fluctuations on the travel-related components of services price inflation (particularly package holidays). Against this background, Eurostat’s flash estimate for May suggests that HICP inflation excluding food and energy stood at 0.9%, after 1.2% in April and 0.7% in March, while HICP inflation excluding food, energy, travel-related items and clothing remained broadly stable in April. The ongoing subdued level of underlying inflation may reflect, in part, the lagged downward indirect effects of past low oil prices, but also, more fundamentally, continued weak domestic cost pressures. As movements in underlying inflation are more closely linked to medium-term inflation trends, convincing signs of an upward adjustment are essential for a sustained adjustment in headline inflation.

There has been a build-up of pipeline pressures at the early stages of the production and pricing chain. The pass-through of the strong pick-up in intermediate goods producer prices to non-food consumer goods producer prices still appears to be weak (see Chart 18). Reflecting the robust rebound in global non-energy producer price inflation that started in mid-2016, annual inflation in intermediate goods producer prices in the euro area continues to gather strength, rising from a low of -2.9% in April 2016 to stand at 4% in April 2017. On the basis of historical regularities, a sustained improvement in intermediate goods producer prices would already imply some recovery in non-food consumer goods price inflation.^[2] However, despite the increase in intermediate goods producer prices and the further increase in import prices of non-food consumer goods, which rose from 0.1% in January 2017 to 1.1% in April, annual inflation in non-food consumer goods producer prices remains subdued and stood at 0.3% in March and April. One possible reason for the weak inflation in the Producer Price Index (PPI) despite increasing price pressures at the earlier stages of the production and pricing chain is that margins are being squeezed.

Euro area wage growth remains low. Annual growth in compensation per employee as well as growth in compensation per hour worked increased somewhat towards the end of 2016. The latest information on annual growth in negotiated wages in the euro area (1.4% in the first quarter of 2017, slightly down from 1.5% in the fourth quarter of 2016) does not point to additional upward pressure at the start of 2017. Overall, wage growth remains low compared with historical averages. This may be attributable to labour market slack – which is still significant according to broader measures of labour market underutilisation^[3] – as well as low inflation, weak productivity growth and the ongoing effects of the labour market reforms implemented in some countries during the financial crisis.

Market-based measures of longer-term inflation expectations have declined somewhat, while survey-based measures have remained stable. Market-based measures have declined across all maturities (see Chart 19). The five-year forward inflation rate five years ahead stood at 1.57% on 7 June 2017, slightly below the level observed at the end of April. By contrast, survey-based measures of longer-term inflation expectations for the euro area, as reported in the ECB Survey of Professional Forecasters for the second quarter of 2017, remained unchanged at 1.8%.

Looking ahead, the increase in HICP inflation in the euro area is expected to be somewhat lower than previously expected. On the basis of the information available in mid-May, the June 2017 Eurosystem staff macroeconomic projections for the euro area foresee HICP inflation to increase from 0.2% in 2016 to 1.5% in 2017, 1.3% in 2018 and 1.6% in 2019 (see Chart 20).^[4] The V-shaped profile of headline inflation over the projection horizon results mainly from a strong positive contribution of HICP energy inflation in 2017, which decreases substantially in 2018. By comparison with the March 2017 ECB staff macroeconomic projections, the outlook for headline HICP inflation has been revised downwards by 0.3 percentage point in 2017 and 2018 and by 0.1 percentage point in 2019. This downward revision mainly reflects lower oil prices.

HICP inflation excluding energy and food is expected to rise only gradually over the medium term. HICP inflation excluding energy and food is projected to increase from 0.9% in 2016 to 1.1% in 2017 and to 1.4% and 1.7% in 2018 and 2019 respectively. One of the main factors behind this gradual pick-up is the envisaged increase in wages and unit labour costs as the recovery progresses and consolidates. Declining labour market slack and a gradual fading of crisis-related factors, which have dampened wage growth over the past few years, are expected to lead to a rebound in growth in compensation per employee and, given a more modest projected recovery in productivity, in unit labour cost growth. The rebound in oil prices since early 2016 is also expected to add, indirectly, somewhat to these upward cost pressures via higher production costs and their repercussions on nominal wages.

Money and credit

Broad money growth continues to expand at a robust pace, while the recovery in loan growth to the private sector observed since the beginning of 2014 is proceeding. The annual flow of total external financing to non-financial corporations is estimated to have strengthened further in the first quarter of 2017.

Growth in broad money remained robust in the first quarter of 2017 and in April, continuing the pace that has been observed since mid-2015. The annual growth rate of M3 stood at 4.9% in April (see Chart 21). The low opportunity cost of holding the most liquid instruments in an environment of very low interest rates, as well as the impact of the ECB’s monetary policy measures, continued to support money growth. As in previous months, annual growth in M3 was mainly supported by its most liquid components; annual M1 growth expanded at an annual rate of 9.2% in April (up from 8.8% in December 2016).

Overnight deposits continued to be the main driver of M3 growth. Specifically, the annual growth rate of overnight deposits held by households and non-financial corporations (NFCs) remained strong in the first quarter of 2017 and in April 2017, to stand at 11.4% and 10.6% respectively. The volatile annual growth rate of overnight deposits held by financial intermediaries (excluding MFIs) increased in March and April. The annual growth rate of currency in circulation increased slightly, without indicating a general tendency by the money-holding sector to substitute deposits with cash in an environment of very low or negative interest rates. Short-term deposits other than overnight deposits (i.e. M2 minus M1) continued to have a negative impact on M3 in the first quarter and in April. The growth rate of marketable instruments (i.e. M3 minus M2) – a small component of M3 – was strong in the first quarter of 2017, supported mainly by solid growth in money market fund shares/units, but became more moderate in April.

Domestic sources of money creation remained the main driver of broad money growth when viewed from the perspective of M3 counterparts (see Chart 22). Among the M3 counterparts, the Eurosystem’s purchases of general government debt securities (see the red portion of the bars in Chart 22), mainly in the context of the ECB’s public sector purchase programme (PSPP), contributed positively to M3 growth. In addition, M3 growth continued to be supported by domestic counterparts other than credit to general government (see the blue portion of the bars in Chart 22). This was driven by the ongoing recovery in credit to the private sector, together with the persistent contraction in MFIs’ longer-term financial liabilities. These longer-term financial liabilities (excluding capital and reserves), whose annual rate of change has been negative since the second quarter of 2012, decreased further in the first quarter of 2017 and in April. The negative annual growth rate was partly due to the impact of the ECB’s targeted longer-term refinancing operations (TLTRO-II), which may be acting as a substitute for longer-term market-based bank funding and reducing the attractiveness for investors of holding long-term deposits and bank bonds. At the same time, government bond sales from euro area MFIs excluding the Eurosystem contributed to the negative annual growth of credit to general government by MFIs excluding the Eurosystem and dampened M3 growth (see the green portion of the bars in Chart 22).

MFIs’ net external assets continued to exert downward pressure on annual M3 growth. They registered a small negative monthly outflow in the first quarter of 2017 and in April. This somewhat increased the downward pressure they exerted on annual M3 growth (see the yellow portion of the bars in Chart 22). This development reflects continuing capital outflows from the euro area. PSPP-related sales of euro area government bonds by non-residents appear to be a factor contributing to this trend (see also the box entitled “Which sectors sold the government securities purchased by the Eurosystem?”).

The recovery in loan growth to the private sector observed since the beginning of 2014 is proceeding. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) increased in the first quarter of 2017 and in April (see Chart 21). Across sectors, the annual growth in loans to NFCs increased further, standing at 2.4% in April (see Chart 23). Overall, growth in loans to NFCs has recovered significantly from the trough in the first quarter of 2014. This development is broad-based across the largest countries, although loan growth rates are still negative in some jurisdictions. The annual growth rate of loans to households increased in the first quarter of 2017 and remained unchanged at 2.4% in April (see Chart 24). The significant decrease in bank lending rates seen across the euro area since summer 2014 (owing notably to the ECB’s non-standard monetary policy measures) and overall improvements in the supply of, and demand for, bank loans have supported these trends. In addition, banks have made progress in consolidating their balance sheets, although the level of non‑performing loans remains high in some countries and may constrain bank lending.

Banks’ funding conditions remained favourable. Banks’ composite cost of debt financing decreased slightly in the first quarter of 2017 and in April (see Chart 25). This was driven by a reduction in bank bond yields, while the cost of deposits remained stable. Banks’ composite cost of debt financing continues to stand at historically low levels. The ECB’s accommodative monetary policy stance, the net redemption of MFIs’ longer-term financial liabilities, the strengthening of bank balance sheets and the receding fragmentation across financial markets have all contributed to these favourable conditions.

Bank lending rates for NFCs and households increased somewhat, but nevertheless remained at very low levels in the first quarter of 2017 and in April (see Charts 26 and 27). The decline in lending rates, which started in early 2014, flattened at the beginning of 2017 and rates have since remained close to their historical lows. The composite bank lending rate for loans to NFCs increased slightly in the first quarter of 2017 and remained broadly stable in April. At the same time, the composite bank lending rate for loans to households for house purchase increased somewhat. Since the announcement of the ECB’s credit easing measures in June 2014, composite bank lending rates for loans to NFCs and households have decreased by significantly more than market reference rates, signalling an improvement in the pass-through of monetary policy measures to bank lending rates. The decrease in banks’ composite funding costs has supported the decline in composite lending rates. Between May 2014 and April 2017, composite lending rates on loans to NFCs and households fell by around 112 basis points and 104 basis points, respectively. The reduction in bank lending rates on NFC loans was particularly strong in vulnerable countries, thereby contributing to mitigating previous asymmetries in monetary policy transmission across countries. Over the same period, the spread between interest rates charged on very small loans (loans of up to €0.25 million) and those charged on large loans (loans of above €1 million) in the euro area narrowed considerably and fell to a new historical low in April 2017. This indicates that small and medium-sized enterprises have generally been benefiting to a greater extent from the decline in bank lending rates than large companies.

The annual flow of total external financing to euro area NFCs is estimated to have strengthened further in the first quarter of 2017. This strengthening reflects continued improvements in bank lending dynamics and robust debt securities issuance. NFCs’ external financing now stands at levels seen at the beginning of 2005 (just before the period of excessive credit growth started). Although the sectoral accounts data show that net issuance of listed shares by NFCs increased markedly in the fourth quarter of 2016, this was due to the completion of a single large merger. Without that merger net issuance would have been negative over the quarter as a result of significant volumes of share buybacks. Non-MFI loans to NFCs also recorded a second consecutive marked quarterly net redemption in the fourth quarter of 2016, reflecting the winding down of one large special purpose entity and continued repayments of debt securities issued by others. Overall, the recovery in NFCs’ external financing observed since early 2014 has been supported by the strengthening of economic activity, further declines in the cost of debt financing, the easing of bank lending conditions and larger numbers of mergers and acquisitions. At the same time, NFCs’ record high cash holdings (which are increasing) have reduced the need for external financing.

Net issuance of debt securities by NFCs became more moderate in April and May 2017, after remaining robust in March. Issuance activity continued to be supported by the ECB’s corporate bond purchases, among other factors. Net issuance of listed shares by NFCs in the first months of 2017 has been modest.

Financing costs for NFCs remain very favourable. The overall nominal cost of external financing for NFCs is estimated to have somewhat increased, on average, in the last two months, to stand in May 2017 at 15 basis points above its historical low in July 2016. This recent rise in the overall cost of financing is explained by a modest increase in the cost of equity, attributable to higher equity risk premia. By contrast, the cost of debt has remained practically unchanged at historical lows since August 2016.

According to the latest round of the Survey on the Access to Finance of Enterprises in the euro area – October 2016 to March 2017, SMEs continued to signal further improvements in the availability of external finance. For the first time since the survey began, SMEs reported that they view the general economic outlook as conducive to the availability of external finance. They again ranked access to finance as their least important problem, although significant cross-country differences remain. On balance, SMEs in the euro area reported improvements in their turnover and debt situation, along with stable profits and rising labour and other costs.

Fiscal developments

The euro area budget deficit is projected to fall further over the projection horizon (2017-19), mainly as a result of improving cyclical conditions and decreasing interest payments. The aggregate fiscal stance for the euro area is projected to be broadly neutral over the period 2017-19. The euro area government debt-to-GDP ratio, although still high, will continue to decline. However, countries with high levels of public debt would benefit from additional consolidation efforts to set their debt-to-GDP ratio firmly on a downward path.

The euro area general government budget deficit is projected to decline further over the projection horizon. Based on the June 2017 Eurosystem staff macroeconomic projections^[5], the general government deficit ratio for the euro area is expected to fall from 1.5% of GDP in 2016 to 1.0% of GDP in 2019 (see the table). The improvement in the fiscal outlook, which is broadly unchanged from the March 2017 projections, is supported mainly by favourable cyclical conditions and declining interest payments, while structural fiscal policy measures are expected to be limited. For a significant majority of euro area countries the projections are less optimistic than those outlined in the respective 2017 stability programme updates, in particular as they relate to the period towards the end of the projection horizon. One reason for this difference is that the stability programme updates include fiscal measures that are either not yet legislated for, or not sufficiently specified to be considered in the projections.

The euro area fiscal stance is projected to be broadly neutral in 2017-19. ^[6] The stable outlook of the structural primary balance is almost unchanged from the March 2017 exercise. On the revenue side, small cuts in direct taxes in some countries are offset by other revenue factors (mainly reflecting a change in the statistical recording of the universal mobile telecommunications system (UMTS) proceeds). On the expenditure side, government investment and social payments are projected to grow slightly above the nominal GDP trend.

Euro area government debt is expected to continue to decline from its current high level. The euro area government debt-to-GDP ratio, which peaked in 2014, is projected to decline further from 89.2% in 2016 to 84.7% by the end of 2019. The projected reduction in government debt is supported mainly by favourable developments in the interest rate-growth differential, in the light of a robust macroeconomic outlook and low interest rates. The expected primary surpluses will be contributing to the decline in the government debt-to-GDP ratio, while the deficit-debt adjustments are expected to have a small debt-increasing impact. Compared with the March 2017 projections, the aggregate debt-to-GDP ratio for the euro area is expected to be broadly unchanged, except for a marginally better outlook at the end of the projection horizon. In the majority of euro area countries the debt-to-GDP ratio is projected to decline, while in a few countries it is expected to increase.

Countries need to continue with their fiscal efforts in full compliance with the Stability and Growth Pact. Particularly in the case of the high-debt countries, further consolidation efforts are essential to set the public debt-to-GDP ratio firmly on a downward path; their high debt levels make these countries particularly vulnerable to any renewed financial market instability or a rapid rebound in interest rates. On 16 May 2017 the European Commission issued its proposals for the annual country-specific recommendations (CSRs), setting out guidance on the EU countries’ economic and fiscal policies, which eventually will be adopted by the Council. For an assessment of the fiscal policy-related CSRs, see the box entitled “Country-specific recommendations for fiscal policies under the 2017 European Semester” in this issue of the Economic Bulletin.

Further progress is needed with respect to the EU fiscal governance framework. In particular, the fiscal compact, if fully transposed into national legislation and implemented, should strengthen fiscal discipline and increase ownership of the fiscal governance framework at the national level. However, as argued in the box entitled “Fiscal compact: the Commission’s review and the way forward”, it seems that in some countries the fiscal compact has only partially been transposed into national legislation. Looking further ahead, the European Commission has contributed to the discussion on the future of Europe with its “Reflection paper on the deepening of the economic and monetary union”, published on 31 May 2017, which includes, inter alia, proposals on how to progress towards a fiscal union.^[7]

Boxes

The recent evolution of global risks – an assessment

This box provides a qualitative assessment of how key global risks have evolved since early 2016.

Risks of an abrupt shift in global financial conditions appear to have eased but not disappeared. Since the “taper tantrum” episode in 2013, when expectations regarding US monetary policy shifted abruptly, a combination of careful communication and a very gradual approach to monetary tightening by the US Federal Reserve System appears to have mitigated such risks somewhat. In particular, the gap between market expectations and Federal Open Market Committee (FOMC) projections regarding interest rates has narrowed (see Chart A), suggesting that the prospect of monetary policy surprises has diminished. However, uncertainty about the tightening cycle in the United States remains and, despite the modest rebound in the term premium since mid-2016, longer-term interest rates remain very low.

At the same time major emerging market economies (EMEs) seem better placed than some years ago to weather tighter external financing conditions. In recent years vulnerabilities and external imbalances in several EMEs have declined, with real interest rates increasing, inflation falling, credit growth slowing and current account imbalances declining. This should make them more resilient to adverse external financing shocks. Nonetheless, some EMEs – particularly those with large external debts – remain exposed to an abrupt tightening of global financial conditions. Accordingly, an abrupt reversal in global financial market sentiment weighing on global activity, and particularly EME activity, continues to be a risk to the global outlook.

Policy support for growth has mitigated concerns about the short-term outlook for China. From mid-2015 concerns about the outlook for China were prominent amid fears over the sharp slowdown in activity, capital outflows and the depreciation of the renminbi, compounded by rising policy uncertainty. A robust policy response – including substantial fiscal support, infrastructure spending, looser financial conditions and tightened capital controls – alleviated such worries. By underscoring the authorities’ determination to maintain growth close to targets, it may have helped to allay concerns about the near-term outlook. However, the policy response came with significant costs, including a further increase in leverage and increased resource misallocation (with stimulus again being concentrated on the state-owned sector). Tighter capital controls also helped to fuel a housing market boom, as funds were channelled towards domestic assets.

Policy uncertainty has increased at the global level, with concerns about more inward-looking policies, while geopolitical tensions remain elevated. Geopolitical tensions have been a key downside risk to growth in recent years, although their intensity and location have varied over time, ranging from the conflict in the Middle East and tensions with North Korea and in the South China Sea, to political tension between Turkey and the EU, and their impact on refugee flows towards the EU. Some of these risks are more local or regional in nature, while others have a more global dimension, and their probabilities and impacts are difficult to estimate. An index of geopolitical tensions, which captures incidents of war, political tension and terrorist attacks, shows a broadly stable level between early 2016 and the start of 2017.^[8] Moreover, since the US election pressures for more inward-looking policies have risen. Overall, global policy uncertainty has trended upwards in recent years (see Chart B).

The medium-term risks of an adverse fall-out from Brexit persist. The immediate impact of the UK referendum on EU membership has been more benign than initially expected. Activity in the United Kingdom was relatively robust in 2016, although it moderated early this year as inflation rose following the pound sterling’s depreciation. The dispersion of forecasts compiled by Consensus Economics has narrowed (see Chart C), although it remains wider than in the pre-referendum period. Nonetheless, medium-term risks persist, particularly related to the outcome of the negotiations on the conditions for leaving the EU and future trade.

In sum, the analysis suggests that existing downside risks to global growth may have declined over the past year, but have not disappeared. Moreover, new risks have emerged. On the one hand, careful communication by the Federal Reserve System, coupled with a very gradual course of monetary policy tightening and the decline in vulnerabilities in major EMEs, appears to have eased the risk of a disorderly tightening of global financial conditions. On the other hand, although policy actions to support activity have helped allay concerns about the near-term prospects for China, medium-term vulnerabilities remain elevated, given further increases in leverage. In addition, geopolitical tensions remain high. At the same time, new sources of risk have emerged – in particular, there is significant policy uncertainty surrounding the intentions of the new US Administration regarding fiscal and, especially, trade policies, the latter entailing potentially significant negative effects on the global economy. Moreover, the expected gradual recovery of the world economy is contingent on a number of important assumptions about policy, and it remains heavily reliant on ongoing monetary and fiscal policy support. Overall, therefore, although some risks appear to have diminished, the balance of risks to the global outlook remains tilted to the downside.

The ECB’s corporate sector purchase programme: its implementation and impact

8 June 2017 marked the first anniversary of the start of the corporate sector purchase programme (CSPP) ^[9] . The CSPP is part of the Eurosystem’s expanded asset purchase programme (APP) and was introduced with the aim of strengthening the pass-through of the Eurosystem’s asset purchases to financing conditions of the real economy.

The universe of CSPP-eligible bonds is deliberately broad and its composition is primarily guided by monetary policy and risk management considerations. In pursuing its objective of maintaining price stability, the ECB is mandated to act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources. Consequently, the ECB aims for a market-neutral implementation of the APP, and therefore CSPP purchases are conducted according to a benchmark that reflects proportionally the market value of eligible bonds.^[10]

The composition of CSPP holdings generally mirrors that of the CSPP-eligible bond universe. CSPP holdings stood at €92 billion as at 7 June 2017, corresponding to around 11% of the CSPP-eligible bond universe. Holdings are well diversified over around 950 securities issued by around 200 issuer groups. The breakdown of CSPP holdings by country of risk follows that of the CSPP-eligible bond universe very closely (see Chart A). Nor are there any major deviations between CSPP holdings and their respective shares in the CSPP-eligible universe in terms of sectors of economic activity or rating groups. 12% of CSPP holdings were purchased at negative yields, but above the level of the deposit facility rate.

To ensure the effectiveness of monetary policy while maintaining a level playing field for all market participants and avoiding undue market distortions, there is no positive or negative discrimination in the CSPP-eligible bond universe on the basis of environmental or social criteria. While the ECB shares the view that an awareness of environmental issues, together with ethical and socially responsible behaviour, are important for society, it is nevertheless up to political decision-makers (in the first instance) to agree on, define and promote appropriate policies and measures. It is not, however, possible to embed these into a large-scale asset purchase programme that is carried out as a temporary monetary policy measure over a relatively short period of time. To do so would limit the effectiveness of the APP in its contribution to fulfilling the ECB’s mandate of maintaining price stability. It is worth noting that a number of assets classified as “green bonds” are eligible for the CSPP and have also been purchased by the Eurosystem. The holdings of these bonds are broadly in line with their weightings in the benchmark.

The pace of purchases under the CSPP depends on prevailing market conditions. Monthly net purchases during the period from June 2016 to May 2017 (inclusive) have ranged between just below €4 billion and just below €10 billion (see Chart B). Purchases were particularly low ahead of the year-end, which is a period typically characterised by negligible bond issuance and low secondary market liquidity.

Purchases under the CSPP are made in both the primary and the secondary markets; since its inception 15% of CSPP holdings have been purchased in the primary market. Owing to these primary market purchases and to better liquidity in newly issued bonds, CSPP holdings tend to be skewed towards bonds issued more recently; more than half are in bonds issued in 2016 and 2017 (see Chart C). Investor demand for CSPP-eligible corporate bond issuances was, on average, around three times higher than the issued amount. Issuers generally treat the Eurosystem similarly to most other investors in terms of final allocations.

The corporate bond market has developed positively since the announcement of the CSPP in March 2016. The announcement had a measurable effect at the time on secondary market pricing in the corporate bond market^[11]. Euro area corporate bond yields continued to decline in the period following the announcement until the autumn of 2016 (see Chart D), when they again increased amid an expansion in the supply of new bonds and a rise in risk premia globally. Since the beginning of 2017, euro area corporate bond yields have declined overall amid relatively low volatility. Market liquidity conditions remain generally favourable for CSPP bond purchases by the Eurosystem.

Risk premia in the CSPP-eligible bond market have been contained and have shown resilience to shocks. The credit premium has been in almost continuous decline since the CSPP announcement (see Chart E); according to feedback from market participants, this reflects (among other factors) investor appetite for bonds issued by lower-rated companies. Market participants also note that, as a consequence of the CSPP, investors are rebalancing their portfolios to favour more risky non-eligible assets or to adjust the geographical distribution to holdings outside the euro area. The term premium also declined throughout most of 2016, before increasing again in the fourth quarter of that year. According to market participants, some investors are becoming less willing to assume exposure to term risk in the corporate bond market, in anticipation of a possible global rise in interest rates. The liquidity premium has been on a slight downward trend since the start of the CSPP; this is a positive sign of a well-functioning market^[12].

Financing conditions for corporations have improved. Market participants mention the CSPP as a factor that has supported the ability of companies to issue bonds and deepened the corporate bond market. However, the CSPP does not appear to have directly triggered an increase in issuance by new or infrequent euro area issuers (see Chart F).

The annual growth rate of corporate bond issuance has generally increased since spring 2016 and reached around 10% in the first months of 2017. Bond issuance by euro area non-financial companies (NFCs) increased particularly during the period from 2009 to 2010 and in 2013, when it served as a substitute for bank loans against the background of a decline in lending activity by banks to NFCs. Recent growth in issuance, by contrast, has taken place amid an increase in bank loans and has therefore complemented bank lending in supporting corporate sector financing (see Chart G).

The CSPP has also benefited companies which do not rely on capital markets for their financing. This is particularly so in the case of small and medium-sized enterprises (SMEs), since favourable bond market conditions have resulted in positive spill-over effects which have supported bank lending through various channels. For example, when large corporations increasingly finance themselves through bond issuances (rather than bank loans) this releases capacity in the balance sheets of banks for potential lending to SMEs. The results of the Survey on the Access to Finance of Enterprises in the euro area – October 2016 to March 2017 confirm that SMEs continued to benefit from the increased availability of bank loans at lower interest rates than reported in the previous survey.

Liquidity conditions and monetary policy operations in the period from 25 January to 2 May 2017

This box describes the ECB’s monetary policy operations during the first and second reserve maintenance periods of 2017, which ran from 25 January to 14 March 2017 and from 15 March to 2 May 2017 respectively. During these periods 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.

On 29 March the fourth targeted longer-term refinancing operation (TLTRO) in the second series of TLTROs (TLTRO-II) was settled and provided €233.4 billion to 474 bidders. The level of participation was significantly above market expectations and mostly related to the attractive pricing and the fact that this operation was the last in the series. The liquidity injected by the operation was only slightly offset by voluntary repayments in respect of the first and the second operations of the first series of TLTROs (TLTRO-I), which absorbed €16.7 billion. As a result of the net liquidity injection of €216.7 billion, the total outstanding amount under both TLTRO programmes rose to stand at €761.7 billion at the end of the review period. The settlement of the fourth TLTRO-II operation coincided with a decline in the average MRO allotment compared with the seventh and eighth maintenance periods of 2016, which fell by €10.5 billion to €23.8 billion.

In addition, the Eurosystem continued to buy public sector securities, covered bonds, asset-backed securities and corporate sector securities as part of its expanded asset purchase programme (APP), with a target of €80 billion of purchases on average per month until March 2017 and a reduced target of €60 billion per month from April 2017.

Liquidity needs

In the period under review the average daily liquidity needs of the euro area banking system, defined as the sum of autonomous factors and reserve requirements, stood at €1,086.2 billion – an increase of €93 billion compared with the previous review period (i.e. the seventh and eighth maintenance periods of 2016). This increase in liquidity needs was attributable almost exclusively to an increase in average net autonomous factors, which rose by €90.6 billion to a record high of €965.7 billion during the period under review, while minimum reserve requirements rose only marginally, increasing by €2.5 billion to €120.5 billion.

The growth in aggregate autonomous factors mainly resulted from an increase in liquidity-absorbing factors. The main contribution was made by government deposits, which grew by €19.1 billion to stand at €171.1 billion on average in the period under review. Average other autonomous factors also increased, rising by €15.7 billion to stand at €698 billion. Average demand for banknotes rose by only €4.1 billion to stand at €1,146.6 billion, stabilising after the usual year-end increase.

In addition, liquidity-providing autonomous factors decreased over the review period, as a result of the continuing decline in net assets denominated in euro and a slight decrease in net foreign assets. Average net assets denominated in euro fell to €347.8 billion, down €40.6 billion from the previous review period, on account of a decline in financial assets held by the Eurosystem for purposes other than monetary policy. Moreover, there was an increase in liabilities held with national central banks by foreign official institutions. Average net foreign assets decreased by €11.1 billion to €670.5 billion.

The volatility of autonomous factors remained elevated at levels broadly unchanged from the previous review period. That volatility primarily reflected fluctuations in both government deposits and net assets denominated in euro.

Liquidity provided through monetary policy instruments

The average amount of liquidity provided through open market operations – both tender operations and the asset purchase programmes – increased by €321.1 billion to stand at €2,501 billion at the end of the period (see the chart). This increase was primarily due to the ECB’s expanded APP and the fourth TLTRO-II operation, which was settled for an amount of €233.4 billion on 29 March 2017.

The average amount of liquidity provided through tender operations increased by €91.4 billion to stand at €654.6 billion. The increase in the liquidity provided by TLTROs more than offset the decline in the liquidity supplied via regular operations. Average liquidity provided via MROs and three-month LTROs decreased by €10.5 billion and €5 billion respectively, while the average outstanding amount under the TLTROs increased by €106.9 billion as a net effect of the settlement of the fourth TLTRO-II operation and voluntary early repayments of funds borrowed via the first and second operations of the TLTRO-I series.

Average liquidity provided through the APP increased by €229.7 billion to stand at €1,846.4 billion, mainly on account of the public sector purchase programme (PSPP). Average liquidity provided under the PSPP, the third covered bond purchase programme, the asset-backed securities purchase programme and the corporate sector purchase programme rose on average by €200.8 billion, €10.5 billion, €1.4 billion and €23.1 billion respectively. The redemption of bonds held under the Securities Markets Programme and the first and second covered bond purchase programmes totalled €6.1 billion.

Excess liquidity

As a consequence of the developments detailed above, average excess liquidity rose by €228.1 billion to stand at €1,414.8 billion in the period under review (see the chart). Most of that increase materialised in the second maintenance period of 2017, when average excess liquidity rose by €190.7 billion on account of liquidity provided by the fourth operation of the TLTRO-II series. At the same time, the target for average monthly asset purchases under the purchase programmes was reduced to €60 billion from April 2017. The smaller increase of €84.9 billion recorded in the first maintenance period was largely due to developments in the liquidity provided by outright purchases, which increased by €116.6 billion but was partially offset by a €20.2 billion decline in liquidity-providing autonomous factors.

The increase in excess liquidity translated into higher average current account holdings, which rose by €153.2 billion to stand at €1,021 billion in the period under review, while the average recourse to the deposit facility increased further, rising by €77.5 billion to stand at €514.6 billion.

Interest rate developments

Overnight money market rates remained close to the deposit facility rate, with rates for specific collateral baskets in the secured segments even falling below that level. In the unsecured market, the euro overnight index average (EONIA) averaged −0.354%, down marginally from an average of −0.350% in the previous review period. The EONIA fluctuated within a relatively narrow range, recording a high of −0.345% on the final day of both January and February 2017 and a historical low of −0.363% in the run-up to the end of April. Furthermore, in the secured market, average overnight repo rates in the GC Pooling market^[13] declined slightly, with the standard collateral basket standing at −0.423% and the extended basket standing at −0.403%, down 0.018 and 0.005 percentage point respectively relative to the previous review period.

The quarter-end decline in the core repo rates recorded in March was less pronounced than the decline recorded at the year-end. This may be taken as an indication that market participants prepared earlier, and to a greater degree, for collateral liquidity shortfalls. Moreover, this development could reflect positive effects from the cash collateral facility for PSPP securities lending.

Recent developments in the euro area current account balance

Since the start of the decade the euro area current account balance has risen steadily from a broadly balanced position to a surplus. In 2016 the surplus stabilised at just above 3% of GDP. This box looks into the main factors behind this development.

In 2016 the euro area registered a current account surplus of 3.3% of GDP, slightly above the 3.2% recorded in 2015. The deficits in the oil trade balance and combined income balance contracted modestly, while the surplus in the non-oil trade balance continued to shrink (see Chart A). The small overall increase in the current account surplus in 2016 masks the fact that the surplus started to decrease on a four-quarter average basis in the second half of the year, when oil prices recovered somewhat. This development contrasts with the period between mid-2014 and mid-2016 when the shrinking of the oil trade deficit due to the decline in oil prices almost entirely explained the widening of the euro area’s current account surplus.^[14]

Euro area imports and exports declined relative to GDP in 2016 as a result of price developments which more than offset an increase in trade volumes (see Chart B). The decline in nominal trade relative to GDP was driven by falling import and export prices, while the overall GDP deflator increased in 2016.^[15] However, in volume terms, euro area trade expanded at a faster pace than GDP, with real imports rising by 4.0% and real exports by 2.9%, while real GDP grew by 1.7%. The robust growth in trade volumes is consistent with the ongoing recovery in the euro area and the global economy. Since the drop in nominal trade flows relative to GDP was more pronounced for exports than for imports, the euro area trade surplus decreased slightly.

The euro area’s trade surpluses vis-à-vis the non-euro area EU countries and the United States declined by around 0.1% of GDP in 2016 compared with 2015, while its deficits with China and Russia shrank by 0.2% and 0.1% of GDP respectively (see Chart C). ^[16] In 2016 the euro area’s bilateral trade surplus vis-à-vis the non-euro area EU countries stood at around 2% of GDP, while the surplus accrued with the United States was around 0.9% of GDP. The United Kingdom accounted for around three-quarters of the trade surplus vis-à-vis the non-euro area EU countries in 2016. At the same time, the euro area recorded trade deficits vis-à-vis China and Russia, of -0.6% and -0.2% of GDP respectively.

From a saving-investment perspective, the stabilisation in the current account balance in 2016 reflects a pick-up in investment which broadly offset the continuing increase in gross saving (see Chart D). According to a simple accounting identity, the current account balance broadly corresponds to the gap between domestic saving and investment, i.e. net lending or net borrowing. The widening of the euro area’s net lending position in previous years reflected a steady increase in gross saving and subdued investment (relative to GDP). Since economic activity started to recover in 2013, however, both the saving and the investment to GDP ratios have edged up. The private sector currently registers a net lending position, while the public sector continues to record a net borrowing position, which, however, has shrunk significantly in recent years.

Germany contributed most to the euro area current account surplus in 2016, although other countries also made significant contributions (see Chart E). In 2016 Germany’s current account surplus stood at 2.4% of euro area GDP, followed by the Netherlands (0.6%), while positive contributions of between 0.1% and 0.4% of euro area GDP were made by Italy, Spain and Ireland. By contrast, France recorded a current account deficit of 0.2% of euro area GDP.

At the euro area country level, the current account developments in 2016 were relatively heterogeneous (see Chart F). During the external adjustment process over recent years, euro area countries that had large current account deficits before the global financial crisis have seen a significant correction and, in many cases, have turned these deficits into surpluses. In 2016, the most notable current account improvements compared with 2015 were observed in Malta and Latvia, while the current account surpluses of Slovenia, Italy, Portugal, Spain and Estonia also increased further. The most pronounced current account deterioration, albeit starting from an elevated surplus, was recorded in Ireland, followed by Cyprus which recorded an increasing deficit. The sizeable and persistent current account surpluses of Germany, the Netherlands and Luxembourg narrowed slightly in 2016.

Private sector indebtedness and deleveraging in the euro area countries

Rising private sector debt-to-GDP ratios have been a pre-crisis feature of many euro area countries. In the run-up to the financial crisis, buoyant demand growth and the associated credit boom led to the build-up of large volumes of domestic debt in several euro area countries. Private sector debt (i.e. debt of households and non-financial corporations)^[17] in the euro area as a whole rose from 110% of GDP in 1999 to 147% of GDP in 2009 (see Chart A). For most euro area countries the increase from 1999 to the peak has been significantly higher than that observed for the euro area as a whole (see Chart B). Only in Germany has the private sector debt-to-GDP ratio been on a downwards path since 1999. The private sector debt-to-GDP ratio, which can be considered a measure of medium- to long-term affordability of debt, clearly showed an upwards trend prior to 2009. But such a trend is much less evident when looking at debt as a percentage of total assets (the leverage ratio) – which, during the pre-crisis expansionary period, did not signal a possible build-up of over-indebtedness. The leverage ratio is measured on the basis of market prices of assets, and the evolution of these asset prices has partially hidden the vulnerability associated with the increase in indebtedness. This box reviews recent developments in private sector indebtedness and deleveraging, focusing on the debt-to-GDP ratio as a measure.

Since reaching its peak in 2009, private sector debt as a percentage of GDP has been on a slight downwards trend in the euro area as a whole. From 147% of GDP in 2009, private sector debt fell to 139% of GDP in 2016. This relatively modest decline hides significant differences across countries. In some highly indebted countries private sector debt-to-GDP ratios have been falling significantly since their peak. The reduction in the ratio has been very marked in Spain (54 percentage points since the peak in 2009), amounting to half of the increase over the previous ten years; the reduction has also been significant in Estonia, Latvia, Lithuania, Luxembourg, Malta, Portugal and Slovenia (see Chart B). By contrast, other highly indebted countries (with a private sector debt-to-GDP ratio above 200%), namely Ireland, Cyprus and the Netherlands, have not shown any major decline in their ratios. Private sector debt-to-GDP ratios have been growing continuously over the past 18 years in Belgium, France, Slovakia and Finland.

Even after the post-crisis adjustment, private sector debt-to-GDP ratios have remained very heterogeneous across countries in the euro area. Chart C shows that private sector debt ratios at the end of 2016 ranged from about 50% of GDP to 350% of GDP. In most countries, private sector debt ratios are above 100% of GDP and the threshold in the scoreboard of the Macroeconomic Imbalance Procedure (133% of GDP) is exceeded by ten euro area countries (see Chart C). While this threshold is a purely statistical indicator^[18], which does not take into account economic fundamentals, it signals that in some countries deleveraging needs might still exist. It should be noted that a conclusive assessment of the extent of deleveraging needs would also require a supplementary analysis of the distribution of debt across households and non-financial corporations, together with their respective underlying characteristics.

The decomposition between debt held by households (HHs) and by non-financial corporations (NFCs) shows that the proportion of the latter is on average larger. There are three exceptions: Germany, where the proportion of debt held by HHs is higher than that held by NFCs; and Greece and the Netherlands, where the proportion of debt held by each sector is approximately equal. The NFC debt-to-GDP ratio is very high in Ireland, Cyprus and Luxembourg. In these countries the value of NFC-held debt is, however, particularly affected by large cross-border intra-company loans.

There is a growing body of empirical literature which shows that high levels of private sector debt can have significant adverse effects on future economic outcomes. While private indebtedness, at moderate levels, helps to smooth consumption and enhance economic growth, an excessive increase in private sector debt over the medium term can affect capital accumulation and lead to lower economic growth.^[19] This occurs because investment is reduced as companies need income to repay their debt and private consumption is also reduced as overleveraged households need to increase savings to cover debt service obligations. Moreover, banks’ lending suffers as high private sector indebtedness is often associated with rising non-performing loans, which tend to erode banks’ capital buffers.^[20] Some empirical analysis shows that these adverse effects occur only above a certain threshold.^[21] There is also evidence that delays in dealing with debt overhangs can lead to lower firm exit rates and can significantly affect the degree of capital and labour reallocation across firms and sectors which, in the medium term, lowers aggregate productivity in the economy.^[22] It is therefore important to monitor developments in private sector indebtedness, the risk of debt overhang and any consequence associated with high deleveraging needs.

The deleveraging process across euro area countries has come about as a result of both nominal GDP growth and a reduction in private debt. Empirical evidence shows that a rapid and front-loaded deleveraging process tends to be associated with medium-term output gains.^[23] This also seems to be the case in the experience of the euro area, where early and swift deleveraging episodes (e.g. in Estonia, Ireland, Spain, Latvia, Lithuania and Slovenia) have been associated with subsequent higher real GDP growth per capita (see Chart D). Chart E shows that in four countries (Greece, Spain, Portugal and Slovenia) the deleveraging process has occurred mainly through a reduction in nominal debt, i.e. via debt repayments or write-offs. In five countries (Italy, Cyprus, Latvia, Lithuania and the Netherlands) it occurred as a result of a combination of a reduction in nominal debt and an increase in nominal GDP. In five countries (Germany, Estonia, Ireland, Malta and Austria) deleveraging was driven exclusively by nominal GDP growth. The chart also shows that unfavourable nominal GDP developments caused headwinds for the debt-reduction process in Greece, Cyprus and Portugal.

The current deleveraging process has been supported by a significant reduction in interest payments. The maturity structure and the interest payments measure the short-term debt burden and thus can provide information about short term risks associated with the ability to meet debt repayment schedules. While aggregate data on the average maturity structure of loans and securities across households and firms are not widely available, a short-term indicator of borrower stress can be defined as the ratio of interest payments to income. This indicator is shown in Chart F, where the blue line represents the average interest payment-to-income ratio for the euro area, and the shaded areas represent the interquartile range across the euro area countries. Both HH and NFC interest payment-to-income ratios demonstrate a common downwards trend, in particular since 2009. For the euro area as a whole, the average of household interest payments has decreased from 4.1% (in 2008) to 0.9% (in 2016) of gross disposable income, while the average of NFC interest payments fell from 19.4% (in 2008) to 6.5% (in 2016) of gross operating surplus. However, heterogeneity across countries differs between the two sectors. While the cross-country variation of the household interest burden seems to have fallen since the crisis, heterogeneity in interest payment-to-income ratios for NFCs remains relatively significant. The higher heterogeneity found for NFCs indicates that across countries the risk premium associated with NFC debt is currently higher than that associated with HH debt.

Looking forward, and given the high debt levels in some countries, deleveraging needs might continue to exist. This box has shown that the recovery in GDP and the low interest rate environment have helped the deleveraging process. Further deleveraging could take place via the expansion of nominal GDP. From a policy perspective, better debt workout mechanisms would facilitate balance sheet adjustments. In particular, policies to further improve insolvency frameworks, including enhanced efficiency of judicial processes and out-of-court mechanisms, could make a significant contribution to a swift and sustainable reduction of non-performing debt, lead to more efficient rescues of viable firms and increase debt recovery for lenders.

Which sectors sold the government securities purchased by the Eurosystem?

At the end of 2014, immediately prior to the start of the public sector purchase programme (PSPP), three sectors held almost three-quarters of all debt securities issued by euro area governments. The non-euro area residents sector, a heterogeneous sector mainly comprising large institutional investors (both private and public), but also including very active market participants, held the largest share, accounting for 30% of the total outstanding amounts. Monetary financial institutions (MFIs) other than the Eurosystem (henceforth simply MFIs) held 22%. Insurance corporations and pension funds (ICPFs), typically characterised as long-term investors with strong preferences for specific maturity brackets, held 20%. Among the remaining sectors, investment funds other than money-market funds had the largest holding, amounting to 11% of outstanding euro area government securities. The remainder was distributed between the Eurosystem (7%) and all other sectors as a whole (households, non-financial corporations and financial intermediaries not classified in any of the above sectors), which together accounted for the final 10% of the total (see Chart A).

Net of valuation and reclassification effects, the largest declines in holdings of euro area government securities since the start of the PSPP correspond to the non-resident and MFI sectors. Between the second quarter of 2015 and the fourth quarter of 2016 the Eurosystem purchased a net amount of €919 billion.^[24] Practically all other sectors recorded negative flows, with non-residents (−€306 billion) and MFIs (−€217 billion) recording the largest negative flows (see Chart B). However, the analysis of actual flows does not provide an accurate picture of how the Eurosystem purchases have affected the behaviour of each sector with respect to euro area government securities. For instance, ICPFs acquired a net amount of €32 billion in the period from the second quarter of 2015 to the fourth quarter of 2016. This does not mean that the PSPP had no impact on ICPFs’ purchasing of government securities, as the effect can only be calculated relative to the purchases that each sector would have carried out, and how the issuance of new debt securities would have been distributed across sectors, in the absence of the PSPP.

Non-residents and, to a lesser extent, MFIs are estimated to have reduced their holdings of government securities the most in absolute terms since the launch of the PSPP. To analyse each sector’s response to the purchases of government bonds by the Eurosystem, it is first necessary to estimate the net flows that would have occurred in the absence of the PSPP (i.e. the counterfactual flows). This is achieved by using variables that typically determine the purchasing behaviour of each sector but which are not affected by the PSPP.^[25] The impact of the PSPP on each sector’s holdings of government securities is computed as the difference between actual and counterfactual flows.

The results show that between March 2015 and March 2017 non-residents are estimated to have reduced their holdings of euro area government securities by €496 billion relative to the situation that would have prevailed if the net purchases of government securities by the Eurosystem had been zero (see Chart C). This amount is equivalent to 45% of the net purchases of government securities carried out by the Eurosystem in the period from March 2015 to March 2017. An analogous calculation indicates that MFIs reduced their holdings by the equivalent of about 25% (€281 billion) of Eurosystem net purchases. The holdings of investment funds and ICPFs are estimated to have been reduced by the equivalent of 16% and 14% respectively of the net Eurosystem purchases.^[26] These findings are not surprising, given that non-residents and MFIs also had the largest holdings of government securities immediately prior to the launch of the PSPP.

Relative to their initial holdings, non-residents and investment funds are estimated to be the sectors which have reacted most strongly to the Eurosystem purchases. To evaluate the relative response of each sector to the Eurosystem purchases, the estimated impact is expressed relative to the sector’s pre-PSPP holdings. This comparison reveals that non-residents and investment funds showed the strongest response, with the impact on both sectors amounting to about 20% of their holdings of euro area government securities prior to the PSPP. By contrast, the reaction of the ICPF sector, one of the largest holders of government securities, equates to less than 10% of the sector’s pre-PSPP holdings. With 15%, MFIs showed an intermediate reaction. The relatively small response of ICPFs is likely to reflect the investment strategies of this sector, which are dominated by the need to meet their long-term commitments and are subject to considerable regulatory constraints. By contrast, the non-resident and investment fund sectors are likely to comprise a larger share of active market participants, who are more driven by yield considerations.

Country-specific recommendations for fiscal policies under the 2017 European Semester

On 22 May the European Commission issued its country‑specific recommendations for economic and fiscal policies for all EU Member States except Greece, together with recommendations for implementing the European Union’s Stability and Growth Pact (SGP) for individual countries. The country-specific recommendations were finalised and approved by the aforementioned Member States’ economics and finance ministers on 16 June. They are scheduled to be endorsed by the European Council on 22-23 June and will be published in mid-July.^[27] The Council’s fiscal policy recommendations are intended to ensure that EU countries comply with the SGP. To this end, they include assessments of the 2017 updates to stability and convergence programmes, which governments had submitted to the European Commission and the Council in the course of April. In terms of follow-up, the country‑specific recommendations for euro area countries’ fiscal policies issued under the 2017 European Semester should be reflected in governments’ draft budgetary plans for 2018. These plans need to be submitted to the Eurogroup and the European Commission by mid‑October 2017. Against this background, this box examines the recommendations for fiscal policies that were addressed to the 18 euro area countries.

According to the European Commission’s Spring 2017 Economic Forecast, the improvement in the euro area’s budgetary position is accompanied by a split between countries regarding progress towards sustainable public finances. On the one hand, the Commission has assessed eight euro area countries as having achieved their medium-term budgetary objectives (MTOs) in 2016.^[28] This favourable development will help bolster the government budgets of these countries and reduce their government debt over the medium term, making their economies more resilient to adverse economic developments. On the other hand, in a number of other countries structural adjustments are falling short of the requirements of the SGP, despite improving economic conditions. This is delaying the achievement of MTOs and the building of fiscal buffers, which is particularly problematic for countries with high levels of government debt. These countries currently record underlying budgetary positions that tend to be farthest from their MTOs (see table). Looking ahead, such countries risk being constrained in using fiscal policy in a stabilising manner during the next downturn and may even need to revert to pro‑cyclical tightening of budgetary policies. Possible increases in interest rate levels could exert additional budgetary pressures.

The Commission’s country-specific recommendations highlight risks of non‑compliance with the structural adjustment requirements of the SGP in several euro area countries. According to the European Commission, neither France nor Spain, the countries with a deficit above the reference value of 3% of GDP in 2016, are expected to deliver a noticeable structural adjustment over the period 2017-18, i.e. a reduction of their budget deficit through factors other than the impact of the economic cycle and temporary budgetary measures. Moreover, significant shortfalls vis‑à‑vis structural adjustment requirements are anticipated in some countries that are currently under the SGP’s preventive arm and have not yet reached their MTOs. This comes at a time when these structural adjustment requirements have been lowered markedly for some countries in order to cater for a number of factors, including structural reforms, additional government investment and pension reforms, as well as costs incurred for hosting refugees and additional security spending. Overall, this flexibility could reduce the requirements for countries to progress towards their MTO from, on average, an adjustment of around ½% of GDP to one of around ¼% of GDP in 2017.^[29] Nevertheless, these countries are expected to conduct expansionary fiscal policies of, on average, 0.3% of GDP, i.e. policies that further deteriorate their structural balance.

The Commission’s fiscal policy recommendations depart from those in the past in two respects. First, only the recitals of the recommendations, rather than the enacting parts, specify the size of the structural adjustment that the Council recommends governments make to ensure full compliance with the SGP. It is usually the enacting parts that should provide clear ex-ante guidance to governments on how to conduct public finances over the next 12-18 months. They also serve as a guide to parliaments and the general public and as a reference for transparent ex‑post assessments of compliance with the SGP. It is therefore important that the fiscal guidance is fully incorporated, including in governments’ draft budgetary plans for 2018, in order to ensure sufficient progress towards sound public finances. Second, for all countries with structural adjustment requirements of 0.5% of GDP and above in 2018, irrespective of their level of government debt, the recitals state that “the assessment of the 2018 Draft Budgetary Plan and subsequent assessment of 2018 budget outcomes will need to take due account of the goal to achieve a fiscal stance that contributes to both strengthening the ongoing recovery and ensuring the sustainability of [the respective Member State’s] public finances”. This could imply reductions in structural adjustment requirements over and above those granted under the existing flexibility provisions in the SGP (as communicated by the Commission in January 2015).^[30] Going forward, it is important that a consistent implementation of the rules-based SGP is ensured.

On 22 May the European Commission also issued recommendations regarding the implementation of the SGP. The Commission recommended abrogating the excessive deficit procedure (EDP) for Portugal by its 2016 deadline, and the Council adopted a corresponding decision on 16 June. Moreover, in reports prepared under Article 126(3) of the Treaty on the Functioning of the European Union, the Commission examined the breach of the debt criterion in Belgium and Finland in 2016 and decided against opening an EDP. In the case of Finland, the breach of the government debt reference value by 3.6% of GDP was explained by mitigating factors, including the provision of financial support to other euro area countries to safeguard financial stability and the negative impact of the economic cycle. As regards Belgium, the Commission concluded that, for 2016 and 2017 taken together, the country was considered to be at risk of non-compliance with the requirements of the preventive arm of the SGP. The analysis nevertheless suggested that the debt criterion should be considered as currently complied with given that the projected deviation could still be corrected in 2017. As regards Italy, the decision on opening a debt‑based EDP was postponed. The Commission envisages reassessing Italy’s compliance with the debt criterion based on the draft budgetary plan for 2018 and the Commission’s Autumn 2017 Economic Forecast. In general, applications of the SGP’s debt rule which are based on compliance with the preventive arm over the medium term and on data validated ex post risk unduly delaying final decisions on whether or not to open debt-based EDPs. In the meantime shortfalls in structural adjustments vis-à-vis the SGP’s requirements could further increase debt sustainability risks. Going forward, the assessment of compliance with the debt criterion should be further clarified, based on clearly quantifiable factors, to ensure an effective implementation of the SGP’s debt rule.^[31]

To conclude, the SGP has seen frequent amendments and interpretations over time and has thus become very complex. This makes the consistent application of the rules across countries and over time more difficult. At the same time, any fiscal framework is as good as its enforcement. In this regard, the full, legally sound and consistent application of the rules of the Stability and Growth Pact is the joint responsibility of the European Commission and the Council. It is of high importance for the credibility of the Pact.

The fiscal compact: the Commission’s review and the way forward

In response to the sovereign debt crisis, the fiscal compact was set up to foster budgetary discipline and increase national ownership of the fiscal governance framework. This was to be achieved by anchoring in national legislation the principles of sound fiscal policies set out in the Stability and Growth Pact and by ensuring that institutions are in place to support a well‑informed national political debate on these issues.

To achieve these objectives, the fiscal compact ^[32] obliges participating countries to commit legally to a balanced budget rule and to set up institutions to monitor adherence to this rule. The balanced budget rule, which should preferably be enshrined at the constitutional level, is deemed to be respected if a country’s structural balance is in line with its country‑specific medium-term objective (MTO).^[33] Countries which have not yet achieved their MTO should ensure rapid convergence towards it. In the event of significant deviations from the rule, a correction mechanism at the national level should automatically be triggered. With respect to the latter, the Commission has proposed common principles, which, inter alia, specify the nature, size and time frame of the corrective action.^[34] Regarding the institutional monitoring, the governments bound by the fiscal compact have committed to set up national independent fiscal institutions (referred to as fiscal councils) to monitor compliance with the rules. These institutions should also play a role in the activation of the correction mechanism in the event that countries deviate from the rule.^[35] Moreover, in line with the common principles, national authorities should adhere to the “comply or explain” principle when responding to the assessments made by the fiscal councils, i.e. they should either follow the latter’s advice or publicly explain why they are departing from it. The fiscal compact supplements other recent amendments to strengthen the fiscal governance framework at the national level, such as the directive on national budgetary frameworks and the “two-pack” regulations.^[36]

The European Commission published its review of the transposition of the fiscal compact into national legislation in February this year, three years after the transposition deadline (1 January 2014). ^[37] The Commission’s review is crucial, as, if a contracting party is found not to have complied with the transposition requirements, the matter may be brought before the European Court of Justice. Moreover, a country could face a penalty payment of up to 0.1% of GDP if it does not respect the Court’s judgement within a set period.

According to the Commission’s review, all countries have complied with the requirements. However, in some cases the positive assessment is subject to the future adoption of complementary or amended provisions. The review focuses, for each country, on (i) the legal status of the provisions, (ii) the formulation of the balanced budget rule, (iii) the correction mechanism, and (iv) the set-up of the independent fiscal council. Regarding the legal status of the provisions and the formulation of the balanced budget rule, the Commission finds that “all contracting parties have significantly adapted their national fiscal frameworks as a result of the fiscal compact requirements”, notwithstanding national differences. In particular, all contracting parties are found to have put in place a binding balanced budget rule (although only some at the constitutional level) and to have set the lower deficit limit at -0.5% of GDP. However, countries differ in how they aim to ensure rapid convergence towards their respective MTOs. In some countries the definitions of exceptional circumstances, which enable the application of escape clauses, seem broader than in the Stability and Growth Pact. The Commission’s review also points to differences regarding the automaticity of the correction mechanism and the scope of the required corrective action. As regards the fiscal councils, the Commission confirmed that their mandate to monitor rule compliance and their institutional set-up were enshrined in legislation, although with varying degrees of detail.

The Commission’s overall positive assessment contrasts with the fact that the fiscal compact has been only partially transposed in many countries. The Commission’s assessment of “being compliant” is, for several countries, conditional on formal commitments by the national authorities either to implement remaining parts of the fiscal compact or to ensure that they will be fully complied with in the future. Commitments are, however, not an adequate substitute for legal provisions, as they are not enforceable. Formal commitments have been made with regard to the balanced budget rule by the authorities of Denmark, France, Cyprus, Lithuania, the Netherlands and Romania (see table). Moreover, a large number of countries, namely Belgium, Denmark, Greece, Spain, France, Italy, Luxembourg, Austria, Portugal and Slovakia, have not yet formally integrated an unconditional “comply or explain” principle into their legal frameworks. Instead, they have only promised to respect the principle or to amend their legal provisions. Furthermore, regarding the correction mechanism, France’s provisions governing the substance of the mechanism and Latvia’s definition of the escape clause allow for some scope for flexibility. Finally, the Commission concurred with the set‑up and design of the monitoring institutions, although in some countries, namely Belgium, Denmark, Spain, France, Luxembourg and the Netherlands, their independence was not found to be fully ensured by national legislation.

Overall, the slow and incomplete transposition of the fiscal compact is disappointing. It signals a clear risk that the intended anchoring of sound fiscal policy rules at the national level may not materialise. In combination with an implementation of the EU fiscal framework which may be perceived as not sufficiently complete, this could contribute to undermining the credibility of sound fiscal policymaking.

As a follow-up to the review, it will be important to closely monitor whether the authorities fulfil their commitments. The Commission’s review focuses on the question of whether the main elements of the fiscal compact are sufficiently enshrined in national provisions. Neither their practical implementation nor their effectiveness are discussed. Looking ahead, it would be valuable to thoroughly assess the effectiveness of the fiscal compact.^[38] Such effectiveness, realised in the form of better budgetary discipline, can only be ensured if and when countries fully adhere to the agreed commitments contained in the fiscal compact.

Article

Domestic and global drivers of inflation in the euro area

This article discusses the role of domestic and global drivers of inflation in the euro area and whether and how their relative importance has changed over time. Domestic price pressures result mainly from wage and price-setting behaviour, which is closely linked to the domestic business cycle. In respect of external drivers, import prices – especially of commodities – naturally play an important role in the development of domestic headline inflation, for example via energy and food inflation. However, more recently it has been argued that global integration has increased the influence of the global business cycle on domestic inflation and thereby also supported a convergence of inflation developments across the globe. While inflation developments have indeed increasingly shown a common pattern since the early 1990s, this commonality can to a large extent be explained by a change in monetary policy orientation and global commodity price developments. As concerns the effects of globalisation, the theoretically appealing idea that domestic wage and price pressures are increasingly affected by global developments via higher integration and increasing contestability of labour and product markets is difficult to capture empirically. In this respect we find, for example, only limited support for including measures of global slack and of the integration in global value chains in Phillips curve analyses of inflation in the euro area.

1 Introduction

Over the medium term, the overall rate of inflation in an economy is determined by its central bank’s monetary policy. However, over the short term, inflation outcomes are influenced by domestic and external cost and price shocks. On the domestic side, inflation outcomes are typically affected by the balance between aggregate domestic demand and supply, with inflation expectations playing a key role. On the external side, inflation is affected mainly by demand and supply fluctuations in the global economy, which affect the prices of tradable goods, particularly commodities, but also exchange rate developments.

There are a number of reasons why global factors may recently have been playing a more prominent role in shaping domestic inflation dynamics. One argument is that globalisation has made national inflation less responsive to domestic capacity constraints. There are two possible theories for this conclusion: either any sudden expansion in demand for goods would translate into higher imports rather than higher prices; or foreign competition would constrain wage or price increases in industries open to global competition, lowering the sensitivity of wages to domestic demand pressures. It is in this context that China’s integration in the global economy, as discussed in Box 1, has played a central role. Another argument emphasises the role of credible monetary policies that stabilised inflation expectations and trend inflation across advanced and many emerging economies and reduced the volatility of inflation developments and the level of inflation.^[39] Based on the reduced volatility and the lower level of inflation, proportionally more of the variation in national inflation rates would be explained by inflation developments linked to exogenous global price shocks, such as commodity price changes.

In the literature the concept of “global inflation” has come to the fore. This is the notion that domestic inflation rates have converged because of the increased influence of global developments on domestic inflation. One strand of the literature on global inflation has focused on the common – or global – component in national inflation rates and what role it has played in domestic inflation developments.^[40] A second strand has emphasised the importance of global output gaps and integration in global value chains (GVCs) as a determinant of national inflation processes.^[41]

Against this background the article discusses the role played by domestic and external factors with regard to inflation and whether their relative importance has changed over time. The article is structured as follows: the following section discusses the domestic and global drivers of inflation. Section 3 discusses commonalities in inflation developments across the globe. The relative importance of domestic and global factors in the development of euro area inflation after the crisis is analysed in Section 4. Section 5 discusses whether globalisation has changed the importance of global slack for the modelling of domestic inflation based on Phillips curves. The last section concludes.

2 Domestic and external drivers of inflation

In the medium term, inflation expectations play a key role in the achievement of a central bank’s inflation target. Inflation expectations that are firmly anchored in line with the inflation target support the achievement of that goal by guiding wage and price-setting decisions in the economy. Deviations of inflation expectations from the inflation target may become self-reinforcing.^[42] The anchoring of inflation expectations is hence a core task for monetary policy.

In the short term, fluctuations in inflation are affected by both domestic and external developments. The following part discusses the main drivers of inflation on the domestic as well as on the external side. Chart 1 gives a stylised overview of the drivers of inflation in terms of the harmonised index of consumer prices (HICP). The HICP, which is the benchmark indicator for the price stability target of the ECB, is based on a broad basket of goods and services. The main components of the consumption basket used to calculate the HICP are commonly grouped into energy, food, services and non-energy industrial goods (NEIG). HICP inflation excluding energy and food, which consists of services and NEIG inflation, is one measure of underlying inflation.

On the domestic side, price pressures are largely determined by developments in unit labour costs and profit margins. Wages are an important input cost factor for domestic production. In services, which have a weight of two-thirds in HICP inflation excluding energy and food, wages account for the lion’s share of around 50% of input costs and are also an important cost factor for NEIG, with a share of around 20%. To the extent that wages increase more strongly than productivity, they push up unit labour costs and thereby increase cost pressures for firms, which may then feed through to producer prices and, ultimately, consumer prices. The strength of this pass-through depends crucially on profit margin developments, which are closely linked to the pricing power of firms. This pricing power is determined by structural factors, such as the degree of competition and barriers to entry, but varies also cyclically with the ebb and flow of demand.

Domestic price pressures are driven by the domestic business cycle. Unemployment moves with the cycle and low labour market slack tends to put upward pressure on wage growth.^[43] In a similar vein excess demand in economic upturns allows firms to increase their margins, whereas sluggish demand in economic downturns is often accompanied by a reduction in margins, as firms freeze or reduce their prices (in order to maintain their sales) or do not pass on higher input costs (in order not to lose market shares).^[44] The development of profit margins and wages also has important feedback effects on demand via investment decisions of firms and consumption decisions of households, which in turn affect again the likelihood of increases in wages and profit margins. Domestic price pressures can be measured by, for example, the sum of unit labour costs and of unit profits, which is a measure of the costs of domestic production.^[45] Chart 2 illustrates the cyclical behaviour of domestic price pressures, which have closely followed the business cycle in the euro area.

Turning to the external drivers of inflation, import prices for commodities as well as for intermediate and final goods have a considerable impact on domestic inflation via direct and indirect effects. ^[46] For example, oil prices feed directly on energy inflation and imported final goods feed directly on NEIG inflation. Import prices of commodities and intermediate goods also have indirect effects on producer prices via higher input costs, which then feed through the pricing chain.

Commodity prices, as with oil and food prices, are especially important in shaping headline inflation developments. Global factors in domestic inflationary developments are most clearly felt via the impact of oil prices on energy inflation. Energy inflation in the euro area, accounting for around 10% of the consumer goods basket used to measure the HICP, is linked fairly closely to the development of crude oil prices, which are determined on global markets (see Chart 3). Food prices in the euro area are affected by the Common Agricultural Policy and the fact that some markets can be influenced by regional factors such as regulation or health scares; however, global demand and supply forces nonetheless play an important role. Food inflation accounts for around 19% of the HICP goods basket and is somewhat volatile as it is also directly affected by weather events around the globe. As shown in Chart 4, domestic food prices tend to correlate with developments in international food price inflation with some time lag.

Import prices also play an important role in relation to underlying inflation. One channel works via directly imported goods. This is especially relevant for NEIG, of which around 15% are estimated to be directly imported consumer products. Changes in commodity prices also feed through, with some lag, to underlying inflation; this occurs, for example, via the effects of higher import prices for oil on production costs. Such indirect effects^[47] are obvious in relation to some HICP services items, such as transportation services (e.g. aviation), where fuel is a major cost factor. They also affect the prices of NEIG and services that are produced with relatively high oil or energy intensity, such as some pharmaceutical products and some materials used for household maintenance and repair. Finally, import price shocks can lead to second-round effects if their inflationary impact influences wage and price-setting behaviour, which then feed through again to inflation.

The exchange rate has an important role at the juncture between the external and domestic economic environments. As shown in Chart 1, the exchange rate moderates or amplifies the transmission of foreign costs and prices into domestic ones. However, it should be noted that the effects of exchange rate fluctuations on inflation in the euro area depend on a variety of factors, including the macroeconomic environment, factors affecting pricing decisions at the firm level and the shocks driving the exchange rate movements.^[48]

Does foreign slack play a direct role in domestic inflation? The traditional view is that global slack does affect domestic inflation, albeit indirectly. First, global slack has considerable influence on commodity prices, which then affects domestic inflation via import prices for commodities. Second, foreign output gaps matter for short-run inflation dynamics by affecting import prices for these goods. Third, global cyclical conditions affect the domestic output gap indirectly, since stronger global demand for goods and services supports domestic income via the net exports channel. However, the effect that global slack has on domestic inflation may in fact be more direct, as suggested by the “global slack” view^[49]. This view stresses that the range of products that can be traded has broadened and that goods produced in different countries are often close substitutes. This is increasingly also affecting services, which in many instances have become more tradable. Moreover, factor input markets are closely integrated globally due to capital mobility and increasingly similar labour supply characteristics across the globe. In addition, the geographical relocation of production and the fragmentation of production processes into their constituent components have been facilitated by advances in communications technology and the gradual breakdown in trade and financial regulatory barriers.^[50] Another important aspect is that there was also a major longer-term increase in the production potential of the global economy – for example by the integration of China, which plugged an enormous additional labour force, both directly and indirectly, into the global economic system.^[51] Based on all these factors, the global slack view argues that in the case of tradable goods and services, what is decisive is no longer solely the domestic tightness or slack of economic conditions, but the global tightness or slack as well, because local demand and supply conditions for a given tradable good or service can to varying degrees be offset elsewhere. In effect this could lead to domestic inflation being increasingly sensitive to global slack.

Does integration in GVCs affect the role that foreign slack plays in domestic inflation? Recent research suggests that the direct role of foreign slack in domestic inflation depends on integration into GVCs. The increasing role of GVCs has been facilitated by innovations in information and communication technology; such technology makes it possible to coordinate and track just-in-time production at different production stages by different firms around the globe and to shift firm‑specific know-how across borders. These GVCs are also increasingly covering business services. Auer, Borio and Filardo^[52] argue that integration in GVCs further boosts the ability of firms to substitute various production stages across borders via offshoring and outsourcing. This in turn increases the degree of contestability of domestic labour markets as, for example, unions are aware of the credible threat that some production stages may be outsourced to other countries. Such a scenario also makes unions and employers take foreign available production capacity into account in wage negotiations. Moreover, GVC integration also increases the importance of inputs produced abroad, whose prices depend strongly on foreign slack. It is argued that in effect the more the various stages of production take place in intricate networks spanning many countries, the more that external factors and supply conditions elsewhere will tend to have an impact on wage and price-setting decisions of firms; consequently this will also have an impact on the development of domestic inflation.^[53]

3 Commonality in the development of inflation across the globe

Since the late 1990s developments in inflation have increasingly led to a common pattern across the globe being observed. In the last two decades a synchronisation of inflation developments can be seen across a large group of advanced and emerging economies. Euro area inflation has also been very strongly correlated with inflation in the countries of the Organisation for Economic Co‑operation and Development (OECD) with two exceptions: from 1999 to 2002, when there was a period of low inflation following the introduction of the euro;^[54] and, to a lesser extent, between 2014 and 2015 (see Charts 5 and 6).

Since 2007 inflation has been very volatile in the euro area but also across the OECD countries on average. It included two periods of falling inflation (2008-09 and 2012 to early 2015) and a protracted period of low inflation in 2014-16 (see Chart 6). Headline inflation developments have very much been shaped by global commodity prices, with oil prices collapsing in 2008/2009 only to then recover strongly to a very high level before a period of renewed declines in 2014-16.

The strong co-movement of inflation across developed countries has fuelled a debate about whether inflation is or has increasingly become a global phenomenon and is being determined more and more by global factors. Ciccarelli and Mojon for example performed a principal component analysis; they found that inflation in 22 OECD countries has a common factor that can account for on average around 70% of the fluctuations of headline inflation in those same countries in a long sample running from 1960 to 2008. In a more recent contribution, Ferroni and Mojon^[55] apply a similar approach to the same countries and find – for the shorter and more recent period 1993-2014 – global factors playing a somewhat smaller role, explaining only around half of the variance in domestic inflation by common (global) inflation.^[56] They also expand the approach to underlying inflation measured in terms of headline inflation excluding food and energy. Their findings show that 40% of the variation in domestic underlying inflation in the 22 OECD countries studied can be explained by global inflation.

How significant global inflation is vis-à-vis domestic inflation seems to largely depend on the time period studied. Applying a similar methodology to that of Ciccarelli and Mojon for 40 developed and developing countries for headline inflation and 34 countries for inflation excluding food and energy over the sample 1999-2016 suggests that global factors account for around half of domestic headline inflation fluctuations (see Chart 7). However, this proportion has changed over time, with global factors playing a far stronger role in the period 2008-16 than in 1999-2007 in terms of headline inflation. Although the role of global factors in headline inflation excluding food and energy is found to be somewhat smaller, at around one quarter on average, the influence that global factors exert also seems to have been stronger more recently.

Monetary policy orientation plays a role with regard to the commonality in inflation fluctuations across countries. The high degree of synchronisation of inflation across countries (see Chart 5) reflects a common shift in the orientation of monetary policy. The 1990s saw a common downward trend in inflation, particularly in advanced economies, and later on also in some emerging economies. This trend could be attributed to the growing focus of monetary policy authorities towards delivering price stability^[57]. The effectiveness of monetary policy in anchoring domestic price expectations and in reducing the volatility of inflation developments and also the level of inflation would mean that proportionally more of the variation in national inflation rates is linked to exogenous global price shocks, such as commodity price changes.

Global commodity price movements are likely to be the main driver of the global common factor in inflation. In this respect the most important effect stems from global oil price developments, which strongly affect the development of domestic energy inflation.^[58] The common influence of global oil price developments on inflation can be reinforced by the pass-through of energy to underlying inflation, to the extent that this is similar across countries. The same reasoning applies to food and other raw materials inflation, which are also strongly dependent on global commodity price developments. Chart 8 illustrates the importance of commodity prices for the global commonality of headline inflation, as around half of the variation in the common factor can be explained by movements in oil and food commodity prices. This also supports the view that the impact of global factors is changing and depends on how frequent and how large oil and food shocks are.

Commodity price cycles contribute to understanding why the importance of global factors in relation to domestic inflation changes so widely over time. Ciccarelli and Mojon’s findings of the very strong influence that global factors can have seem to be partly driven by the inclusion of data from the 1970s, when central banks failed to prevent energy prices from driving up inflation across the world. This explains why analyses that apply a very similar methodology to a shorter sample – during which monetary policy across the world has been far more successful in dampening inflation swings in the face of strong commodity price movements – find that global factors have a substantially smaller effect. The role that strong energy price swings have played in shaping inflation developments after 2008, which have also fed through to underlying inflation via indirect effects, may partly explain the substantial differences in the role of global factors found in the sub-sample analyses for 1999-2007 and 2008-16 in terms of headline and underlying inflation (see Chart 7).

4 Decomposing the effects of global and domestic factors on inflation in the euro area since the crisis

To better understand the role of global and domestic factors in euro area inflation, this section analyses the period after the crisis, disentangling the role of domestic and global factors and their relative importance over time.

Between 2008 and mid-2013, headline inflation in the euro area has shown strong co-movements with headline inflation in other advanced economies (see Chart 9). Whereas headline inflation peaked in both the non-euro area OECD countries and the euro area in autumn 2011 and fell rapidly thereafter, after 2013 the decline was more pronounced in the euro area. In particular, while inflation dipped into negative territory several times in the euro area in 2015 and 2016, it remained positive for the OECD (excluding the euro area) aggregate. Furthermore, euro area headline inflation continued to hover around zero between end-2014 and autumn-2016.

Gauging the importance of global versus domestic factors in relation to developments in euro area consumer price inflation is not without its complications. First, the various factors are interrelated and affect domestic variables through multiple channels. Second, the impact of global factors on euro area consumer prices depends on how producers and/or retailers adjust their margins as a result of changes in costs. This is subject to local and international market conditions.

An attempt to assess the relevance of global factors to headline inflation developments could begin by considering the individual HICP components. Certain components, notably energy, are more sensitive to global factors than others, such as services, which are more responsive to domestic factors.

A large part of the decline in headline inflation in the euro area and the OECD countries from the end of 2011 until early 2016 has been on account of a decline in energy prices. The most recent pick-up was also mainly driven by the swing in energy prices.

A striking difference between the euro area and the other OECD countries in general is that, since 2013, lower HICP inflation excluding energy and food can explain a much more important, and more stable, part of the euro area disinflation and persistently low inflation. This points to domestic forces having a stronger role in the euro area, and contributing to the fact that HICP inflation excluding energy and food is diverging from that of other advanced economies. HICP inflation excluding energy and food in the euro area has hovered consistently between 0.6% and 1.1% since mid-2013. As Chart 10 shows, according to OECD estimates, the OECD (excluding the euro area) and euro area output gaps were very close to each other until 2012; thereafter the difference between them widened, as the euro area experienced a more negative output gap than the rest of the OECD. The divergence in HICP inflation excluding energy and food between the euro area and other advanced economies, in other words, is largely a matter of domestic economic weakness after 2012.

One approach for distinguishing domestic from global forces is to identify structural shocks and quantify their relative contributions to the dynamics of inflation. This requires a model-based analysis similar to the one applied in Bobeica and Jarociński^[59], whose approach is replicated and updated here. Based on that analysis, Chart 11 shows the contributions of domestic and global shocks to the deviation of euro area headline inflation from a model-based mean. Global shocks are important most of the time, but domestic shocks have had a greater effect, in particular over the period 2012-14, when inflation was falling, and more recently in explaining inflation developments. Global shocks were the principal driver in the two periods from early 2008 to mid-2009 (mainly a global demand shock) and in 2015 to early 2016 (mainly an oil supply shock). They accounted for about 60% and 75% of the deviation respectively. Hence, global factors dominate mainly when large shocks occur that have implications for the whole world economy.

A decomposition of the driving forces of inflation in the euro area thus shows that both global and domestic shocks have played a decisive role in shaping domestic inflation. The relative importance of these shocks can also change quite substantially over time. The empirical results show that both global and domestic factors played a role in determining inflation developments in the euro area from the onset of the crisis. However, the relative importance of global and domestic forces is not so much driven by structural forces, such as globalisation, as by periodic bouts of global shocks, often reflected in large commodity price swings. The next section analyses how the “traditional” Phillips curve fares in terms of explanatory power for euro area underlying inflation developments and whether it can be improved by also taking measures of foreign slack into account.

5 What role do global factors play in a Phillips curve for the euro area?

The Phillips curve, which is broadly understood as the relationship between inflation and economic slack, is a standard framework for explaining and forecasting developments in inflation. The Phillips curve is an important tool that is embedded explicitly or implicitly in many macroeconomic models. However, especially in its strongly simplified versions, the Phillips curve remains a crude tool relative to the complexity of the inflation process. The uncertainty surrounding the adequate modelling of the Phillips curve adds further complications, and so the curve should only be considered as one element in a broader-based analysis of inflation. Nevertheless, it remains a useful frame for understanding inflation.

Phillips curve analyses have traditionally focused on what role domestic slack has in relation to developments in underlying inflation. The focus on underlying inflation – as measured for example in the form of HICP inflation excluding energy and food – allows for inflation to be disregarded in relation to energy and food, which are determined largely by global developments, and to concentrate on services and NEIG inflation, where domestic developments play a more important role. In a benchmark specification of the Phillips curve for the euro area, HICP inflation excluding energy and food depends on the output gap as a measure of slack in the domestic economy. The output gap is meant to cover the effects of slack on wage and price-setting behaviour: all other things being equal, the lower the amount of slack in an economy is, the higher wage and price pressures will be.

External factors are usually taken into account via import prices in Phillips curve specifications. Import prices can influence HICP inflation excluding energy and food in two ways: directly, via the price of imported final consumer goods; and indirectly, via the price of imported intermediate goods used in euro area domestic production.^[65] Import prices also capture the influence of developments in global commodity markets – for example in the form of oil prices, which affect HICP inflation excluding energy and food via the indirect effects of higher import prices for oil on production costs.^[66] Exchange rate movements can amplify or moderate the effects of foreign price developments on euro area inflation. Import prices – including energy imports measured in euro – are hence an important indicator for capturing the effects of oil price and exchange rate developments on HICP inflation excluding energy and food in the euro area in a Phillips curve framework.

A traditional Phillips curve decomposition of the changes in underlying inflation since the crisis illustrates reasonably well how inflation developed in the period from 2010 – with the largest impact stemming from domestic slack. For the purpose of this article, HICP inflation excluding energy and food is modelled using a simple reduced-form “traditional” Phillips curve specification, including a number of explanatory factors, namely: (i) the output gap as a measure of economic slack; (ii) past inflation terms to capture inertia; and (iii) import price inflation expressed in euro to capture the effect of global inflation and the exchange rate.. Chart 12 breaks down HICP inflation excluding energy and food into these factors by showing each factor’s contribution to the deviation of inflation from its long-term mean. In both disinflation periods (2009 until early 2010 and 2012 until early 2015) domestic slack was an important driving factor of the fall in inflation. Lower import prices also had a small downward impact over these periods. The remaining residuals of this Phillips curve decomposition could reflect a number of different factors: these include a potential impact from a mismeasurement of domestic slack in the form of the output gap, but also a potential impact from global factors (over and beyond what is covered by import prices) or the structural impact of reforms on the slope of the Phillips curve.

Is there any indication that globalisation has changed the impact of global cyclical conditions on domestic inflation in a way that cannot be captured by including import prices in Phillips curve analyses? Some of the channels through which global slack may affect domestic inflation may already be captured (at least implicitly) in traditional Phillips curves. As discussed in Section 2, global slack affects import prices, which are usually included in Phillips curve estimates. Measures of domestic slack also incorporate some information about global conditions, since global demand for goods and services is reflected in net trade, and expectations on foreign demand affect investment decisions quite strongly. At the same time, other channels of globalisation are not explicitly captured in the standard Phillips curve framework. In particular, the greater importance of foreign slack for tradable and internationally substitutable goods or the increase in competition from firms in lower-cost countries, including because of further integration in GVCs, may be significant determinants for domestic inflation dynamics.

One way of assessing what role global influences have is to augment the traditional Phillips curve with a measure of foreign slack. The simplest indicator of global inflationary pressures is provided by a global output gap, which measures the difference between world GDP and the estimated potential output of the global economy. Like any output gap measure, it is surrounded by considerable uncertainty because potential output is unobserved and must be estimated. Judging output gaps for an economy is particularly challenging in real time as estimates are often subject to substantial revisions. The same is true for global output gaps and the problem is compounded by the question of the appropriate weighting of the individual countries’ gaps: GDP weights are commonly used for this specific purpose.^[67]

More recently empirical studies have focused on an important transmission channel for the effects of global slack on domestic inflation, i.e. the increasing integration of GVCs. Auer, Borio and Filardo argue that the difference in the sensitivity of domestic inflation with respect to foreign and domestic slack can be explained by integration in GVCs.^[68]

However, the literature provides only limited support for including a measure of foreign slack in traditional Phillips curve analyses. On the one hand, Borio and Filardo found that proxies for global economic slack added considerable explanatory power to traditional benchmark Phillips curve approaches in advanced economies and that the role of global factors had grown over time. The relevance of the global output gap was also supported by Milani in the case of the United States after 1985. On the other hand, other studies (Calza^[69], Gerlach et al.^[70], Ihrig et al.^[71], Martínez-García and Wynne^[72] or Eickmeier and Pijnenburg^[73]) find conflicting evidence and suggest that the Borio and Filardo results are likely to be specific to the estimation sample or particular measurement of the global output. More recently Mikolajun and Lodge^[74] detect no appreciable direct effects of global economic slack on domestic inflation for the majority of advanced economies. Their results provide little evidence of the existence of large direct effects of global slack on domestic inflation and overall suggest that there is little reason to include global factors into traditional reduced-form Phillips curves. However, this analysis is limited to reduced‑form Phillips curves and univariate inflation forecasting models. It might be possible that global slack influences inflation through less direct channels that cannot be captured in this framework. Bianchi and Civelli explore less direct relations within a vector autoregressive model. For a set of 18 countries, they estimate the time‑varying relationship of inflation with both domestic and foreign output gaps, finding that global slack plays a significant role. However, in contrast to the results reached by Borio and Filardo, who inspired them, Bianchi and Civelli do not find that the relative influence of global output gaps has become stronger over time.

Thick modelling analyses find only mixed support for augmenting a traditional Phillips curve for the euro area with a measure of foreign slack and GVC integration. A thick modelling approach, which includes a broad range of up to 108 different Phillips curve specifications combining three different measures of domestic slack, three different measures of foreign slack (combined with six different weighting schemes) and two different measures of GVC integration, with and without interaction terms, allows for the uncertainty about the correct specification of the Phillips curve and the variables used therein to be addressed (for details of the approach taken, see Box 2). This battery of alternative specifications was estimated on a sample spanning the years 2000-16^[75].^[76] As illustrated in Chart 13, the inclusion of some measure of global slack in the Phillips curve can help establish the significant role that foreign slack plays in around one-third of the specifications. If GVCs and foreign slack are included simultaneously, they are significant in around 50% to 60% of the specifications. The GVC measure captures a downward sloping trend, which in some specifications is significant if included in addition to the weighted foreign slack measure. However, the GVC measure is almost never significant when interacted with the global slack, implying that the integration in GVCs does not seem to have an amplifying effect on the role of foreign slack.

6 Conclusion

Drawing on evidence from the available data, models and existing literature, this article contributes to a better understanding of the relative importance of domestic and global factors in shaping inflation in the euro area. A number of conclusions can be drawn.

1. Since the early 1990s a common pattern around the world has been identified regarding inflation developments. However this commonality can to a large extent be explained by a change in monetary policy orientation and global commodity price developments.
2. The role of global factors in domestic inflation varies strongly over time, notably on account of developments in commodity prices. In the case of the euro area, for example, the decline in inflation in 2008-09 was driven predominantly by global factors, whereas domestic factors were more decisive in the disinflation period of 2012-15. This underlines how important comprehensive analyses of the driving factors of inflation are when formulating adequate policy responses.
3. Global developments are thought to increasingly affect domestic wage and price pressures via the integration and contestability of labour and product markets. Although this theory may seem appealing, it is nevertheless difficult to capture empirically. In this respect we find, for example, only limited support for including measures of global slack and measures of integration in GVCs in Phillips curve analyses when studying inflation in the euro area.

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