Update on economic and monetary developments

Summary

The information that has become available since the Governing Council’s monetary policy meeting on 14 June indicates that the euro area economy is proceeding along a solid and broad-based growth path.^[1] Uncertainties related to global factors, notably the threat of protectionism, remain prominent, and the risk of persistent heightened financial market volatility continues to warrant monitoring. However, the risks surrounding the euro area growth outlook can still be assessed as broadly balanced. The underlying strength of the economy has confirmed the Governing Council’s confidence that the sustained convergence of inflation to its aim will continue in the period ahead and will be maintained even after a gradual winding-down of the net asset purchases. Nevertheless, significant monetary policy stimulus is still needed to support the further build-up of domestic price pressures and headline inflation developments over the medium term. This support will continue to be provided by the net asset purchases until the end of the year, by the sizeable stock of acquired assets and the associated reinvestments, and by the Governing Council’s enhanced forward guidance on the key ECB interest rates. In any event, the Governing Council stands ready to adjust all of its instruments as appropriate to ensure that inflation continues to move towards its aim in a sustained manner.

The growth momentum of the global economy continued to be steady in the second quarter of 2018, but downside risks related to trade tariffs have remained prominent. In addition, global trade indicators recorded a loss in momentum. Financial conditions have tightened somewhat for emerging market economies, but overall remain supportive in advanced economies.

In the euro area, sovereign bond yields have declined since the 14 June meeting, on the back of receding volatility in sovereign debt markets and declining risk-free rates. Equity prices experienced a correction amid increasing trade tensions. In foreign exchange markets, the euro broadly appreciated in trade‑weighted terms.

The latest economic indicators have stabilised and continue to point to ongoing solid and broad-based growth, albeit at a slower pace than in 2017. This easing reflects a pull-back from the very high levels of growth last year and is related mainly to weaker impetus from previously very strong external trade, compounded by an increase in uncertainty and some temporary and supply-side factors at both the domestic and the global level. Private consumption continues to be supported by ongoing employment gains, which, in turn, partly reflect past labour market reforms, and by growing household wealth. Business investment is fostered by the favourable financing conditions, rising corporate profitability and solid demand. Housing investment remains robust. In addition, the broad-based expansion in global demand is expected to continue, thus providing impetus to euro area exports.

Euro area annual HICP inflation increased to 2.0% in June, from 1.9% in May, reflecting mainly higher energy and food price inflation. On the basis of current futures prices for oil, annual rates of headline inflation are likely to hover around the current level for the remainder of the year. While measures of underlying inflation remain generally muted, they have been increasing from earlier lows. Domestic cost pressures are strengthening and broadening amid high levels of capacity utilisation and tightening labour markets. Uncertainty around the inflation outlook is receding. Looking ahead, underlying inflation is expected to pick up towards the end of the year and thereafter to increase gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion, the corresponding absorption of economic slack and rising wage growth.

The monetary analysis indicates that broad money growth increased again in June 2018, having gradually decelerated since it last peaked in September 2017. The recovery in the growth of loans to the private sector is proceeding, driven mainly by loans to non-financial corporations (NFCs). The euro area bank lending survey for the second quarter of 2018 suggests that loan growth continued to be supported by easing credit standards and increasing demand across all loan categories. Net issuance of debt securities by euro area NFCs is estimated to have increased further, while financing costs for NFCs have remained favourable.

On the basis of the outcome of the economic analysis and the signals coming from the monetary analysis, the Governing Council confirmed that an ample degree of monetary accommodation is still necessary for the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.

Accordingly, the Governing Council decided to keep the key ECB interest rates unchanged and continues to expect them to remain at their present levels at least through the summer of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term. Regarding non-standard monetary policy measures, the Governing Council confirmed that the Eurosystem will continue to make net purchases under the asset purchase programme (APP) at the current monthly pace of €30 billion until the end of September 2018. The Governing Council anticipates that, after September, subject to incoming data confirming its medium-term inflation outlook, it will reduce the monthly pace of the net asset purchases to €15 billion until the end of December 2018 and then end net purchases. Furthermore, the Governing Council intends to reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of the net asset purchases, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

External environment

Global survey indicators continue to signal a steady growth momentum for the second quarter of 2018. The global composite output Purchasing Managers’ Index (PMI) excluding the euro area increased slightly further in June (see Chart 1), reaching a four-month high, as the continued pick-up in the services sector more than compensated for the moderate decline in manufacturing. In quarterly terms, the PMI in the second quarter of 2018 was slightly above the average in the previous quarter. The composite output PMI in June decreased moderately in the United States from May, while it strengthened in Japan and in the United Kingdom. In emerging market economies, the composite output PMI increased in June in China and bounced back considerably in India, while the rate of expansion slowed in Russia and Brazil.

At the same time downside risks to the global economy have intensified, amid actions and threats regarding trade tariff increases by the United States and possible retaliation by the affected countries. The first wave of US tariffs on Chinese imports took effect on 6 July and further US tariffs are planned. The Chinese authorities revealed their intention to introduce retaliatory measures. Simultaneously, retaliatory measures by the European Union and Canada against the tariffs previously imposed on steel and aluminium came into force. The US administration also initiated a new investigation into imports of cars and spare parts for cars, which, should it result in protectionist measures, could particularly affect Canada, Japan, Mexico and South Korea as well as key economies in the European Union. Complex supply chains could further amplify the adverse effects of protectionism on the world economy. Overall, if all the threatened measures were to be implemented, the average US tariff rate would rise to levels not seen in the last 50 years. These developments constitute a serious risk to the outlook for global trade and activity in the short to medium term.

Global financial conditions remain supportive overall, but have tightened somewhat for emerging market economies. Overall, monetary policy in advanced economies remains accommodative. In the United States, the Federal Open Market Committee increased policy rates in line with expectations in June. Against the backdrop of increasing inflation and tighter labour market conditions, officials at the Federal Reserve System also revised up the path of the federal funds rate to four total hikes in 2018, from the three previously expected. Renewed global trade tensions and the appreciation in the US dollar resulted in somewhat tighter financing conditions for emerging market economies. In China, stock prices also declined and the renminbi faced some depreciation pressures. On the whole, volatility in global equity markets increased and stock prices of automotive and technological sectors came under downward pressures. Central bank interest rates have been maintained in the United Kingdom, and the Bank of Japan is holding ten-year yields close to zero in line with its yield curve control programme. Among emerging market economies, Russia and Brazil have kept rates unchanged in recent months, while Turkey and Argentina hiked rates substantially in May and June amid significant financial market tensions. China has continued to tighten domestic financial conditions to tackle risks in the financial system.

Global trade indicators recorded a loss in momentum. Monthly trade data decelerated significantly and broadly across countries. Global merchandise imports contracted in April and May 2018, reversing the strong growth recorded in the first quarter, and the global PMI for new export orders fell in the five months to June (see Chart 2). Other trade indicators have also weakened, including measures related to global value chains. Overall, these indicators point to a deceleration in trade in the second quarter of 2018.

Global inflation edged up in May. Annual consumer price inflation in the countries of the Organisation for Economic Co-operation and Development (OECD) increased to 2.6% in May. The rise was driven by energy prices, while food prices slowed slightly. Excluding food and energy prices, OECD annual inflation increased marginally to 2%. Inflation is expected to continue rising in the near term following the pick-up in oil prices. Looking further ahead, the gradual decline in spare capacity is also expected to support underlying inflation.

Oil prices have remained broadly stable amid some volatility. Brent crude oil prices increased gradually from around USD 75 per barrel in mid-June to USD 78 per barrel on 10 July, before falling to USD 73 per barrel on 20 July. The effect on oil prices from the announcement by the Organization of the Petroleum Exporting Countries (OPEC) on 22 June of its intention to increase supply has been relatively muted to date. While markets had anticipated an output rise of one million barrels per day, capacity constraints in many OPEC countries suggest a smaller rise in oil supply in the near term. In addition, in July, oil prices were buoyed by strong global oil demand, ongoing geopolitical tensions involving Iran, and political turmoil in Venezuela and in Libya. More recently oil prices have decreased slightly. Non-oil commodity prices have decreased by around 8% since mid-June, with food prices falling by 8% and metal prices dropping by 9%. Food prices fell owing to ample supplies on the back of favourable weather conditions in North America and concerns about rising protectionist threats also affecting food commodities, particularly soybeans. The fall in metal prices can be partly explained by lower demand in China and concerns about a possible trade war.

The outlook for economic activity in the United States remains solid, but concerns about tariffs have arisen among firms. Real GDP expanded at an annualised rate of 2% in the first quarter of 2018. Despite the slight deceleration in activity, the near-term US outlook remains strong, supported by solid fundamentals as well as the large and procyclical fiscal expansion. In particular, consumer confidence is at cyclical highs, and tax cuts should further support domestic demand, even if the recent increase in petrol prices might mitigate somewhat the positive effects of the fiscal expansion. At the same time, anecdotal evidence from regional manufacturing surveys suggest that US businesses are concerned about the impact of a possible further escalation of trade tensions, which may affect their investment spending. The labour market continued to generate jobs at a solid pace and indicators continue to point to tightness, while wage growth remains moderate. Annual headline consumer price index (CPI) inflation reached its highest level since 2012, rising to 2.9% in June, while increasing to 2.3% when food and energy are excluded.

In Japan, the economy is expected to recover from a mild contraction in the first quarter of 2018, but the outlook is surrounded by growing uncertainty. Economic indicators suggest that positive growth in activity resumed in the second quarter, recovering from the first contraction of GDP in two years. However, the outlook is surrounded by growing uncertainty. The intense rainfall in western Japan in early July is expected to weigh on economic activity, as several large manufacturers had to shut down their plants amid the severely damaged infrastructure in the region. In addition, a further escalation of trade tensions could significantly hit the Japanese economy, especially if tariffs are increased on imports of cars and their spare parts, which account for around a third of Japan’s exports to the United States. A further tightening of the labour market seems to be inducing a transition to more secure jobs, amid gradually accelerating base wages and still subdued inflation. Annual headline CPI inflation remained stable at 0.7% in June, yet underlying inflation remained low, with CPI excluding food and energy at 0%.

In the United Kingdom, the weakening in GDP growth over the first quarter of 2018 is considered to be temporary. The third GDP growth release for the first quarter posted a 0.1 percentage point upward revision to 0.2%, mainly due to the upward revision of the net trade component, which also led to a further narrowing of the United Kingdom’s trade deficit. The latest PMI and monthly GDP numbers suggest a rebound in UK GDP in the second quarter, but short-term indicators for the export-oriented manufacturing sector signal a less optimistic outlook. This is in line with an environment of heightened uncertainty, particularly regarding the outcome of the negotiations on the country’s withdrawal from membership of the European Union in March 2019. Inflation stabilised at 2.4% in May, unchanged from April, as movements in the exchange rate have helped offset recent increases in oil prices.

In China, GDP growth moderated slightly in the second quarter of 2018 while financial markets recorded downward pressures. Real GDP grew at 6.7% in year-on-year terms in the second quarter of 2018, in line with market expectations of a slowdown in economic activity. The ongoing structural deleveraging campaign has so far been focused on the banking sector, but it is starting to filter through to the broader economy and is affecting investment patterns. Infrastructure investment in particular fell as financing channels tightened, although investment in manufacturing and real estate rebounded (see the box entitled “Imbalances in China: is growth in peril from a housing market downturn?” in this issue of the Economic Bulletin). Chinese equities and foreign exchange markets have been under pressure recently, reflecting both fears of an escalation of trade tensions and a slowdown in growth. Price pressures picked up in June, with annual headline CPI inflation rising to 1.9%.

Financial developments

Euro area government bond yields have fallen since late June (see Chart 3). In the period under review (from 14 June to 25 July 2018), the GDP-weighted euro area ten-year sovereign bond yield decreased by 7 basis points to 1.04% amid receding tensions in the sovereign debt markets and declining risk-free rates. Vis-à-vis the yield on German ten-year government bonds, the spreads on Italian, Portuguese and French sovereign bonds declined. Long-term sovereign bond yields decreased to 1.27% in the United Kingdom and increased slightly to 2.98% in the United States.

Yield spreads on bonds issued by euro area non-financial corporations (NFCs) changed little over the review period. Compared with late June, the spread on investment-grade NFC bonds relative to the risk-free rate remained unchanged at 57 basis points. Spreads on financial sector debt with an investment-grade rating increased slightly by 4 basis points to levels around 84 basis points. Despite yield increases in the first half of 2018, corporate bond spreads remained significantly (50‑60 basis points) below the levels observed in March 2016, prior to the announcement and subsequent launch of the corporate sector purchase programme.

Broad indices of euro area equity prices experienced a correction amid rising trade tensions. Equity prices of both euro area financials and NFCs decreased by around 2% over the review period on the back of increasing trade tensions. However, expectations of solid corporate profits continued to be supportive of euro area equity prices, reflecting the broad-based improvement in the euro area’s macroeconomic environment. The equity prices of US NFCs and financial firms increased over the review period, by 1.9% and 2.3% respectively. Despite trade tensions, market expectations of future equity price volatility remained relatively low in both the euro area and the United States, where they still stood on an annualised basis at levels (13.5% and 12.3% respectively) that are comparatively low from a historical perspective.

The euro overnight index average (EONIA) remained around -36 basis points over the period under review. Excess liquidity declined by around €70 billion to about €1,817 billion, as the liquidity-draining impact of an increase in net autonomous factors and the settlement of the voluntary repayments of funds borrowed under the targeted longer-term refinancing operations more than offset the provision of liquidity through ongoing purchases under the Eurosystem’s asset purchase programme.^[2]

The EONIA forward curve shifted downwards over the review period. Market participants revised down their interest rate expectations for longer horizons. The curve remains below zero for horizons prior to October 2020, reflecting market expectations of a prolonged period of negative interest rates.

In the foreign exchange markets, the euro broadly appreciated in trade-weighted terms (see Chart 4). Over the period under review, the effective exchange rate of the euro, measured against the currencies of 38 of the euro area’s most important trading partners, strengthened by 1.6%. In bilateral terms, the euro remained broadly unchanged against the US dollar, while it appreciated vis-à-vis all other major currencies, including the Chinese renminbi (by 5.4%), the pound sterling (by 1.3%) and the Japanese yen (by 0.5%), amid the ongoing economic expansion in the euro area. Similarly, the euro strengthened vis-à-vis the currencies of the other non-euro area EU Member States, except the Romanian leu, as well as against the currencies of major emerging economies.

Economic activity

Although incoming data point to a loss in momentum following the very strong growth seen in 2017, the solid and broad-based growth pattern in the euro area is expected to continue. Real GDP increased by 0.4%, quarter on quarter, in the first quarter of 2018, following growth of 0.7% in the five previous quarters (see Chart 5). Domestic demand and changes in inventories made positive contributions to the outcome in the first quarter, whereas net trade had a small dampening effect on GDP growth. Although economic indicators during the first half of this year have softened, they – and particularly the survey results – still remain at very high levels. Overall, this suggests ongoing robust growth in the second and third quarters of the year. The recent strengthening of growth has coincided with a broad-based reduction in growth dispersion across euro area countries (see Box 3).

Employment growth remained robust in the first quarter of the year. Employment rose further, increasing by 0.4%, quarter on quarter, in the first quarter of 2018, and stands 1.9% above the pre-crisis peak recorded in the first quarter of 2008. Employment continues to increase in most euro area countries and the increase is broadly based across sectors. With the latest increase, cumulative employment growth in the euro area since the trough recorded in the second quarter of 2013 amounts to 8.4 million. The strong employment growth seen during the economic expansion was accompanied by broadly unchanged average hours worked, which primarily reflects the impact of several structural factors (for example, the large share of part‑time workers in total employment). In the first quarter of 2018, the average hours worked moderated somewhat, likely reflecting, at least partially, the impact of some temporary factors, such as sick leave and strikes.^[3]

Looking ahead, short-term indicators point to continued strength in the labour market in the coming quarters. The euro area headline unemployment rate declined further to 8.4% in May (see Chart 6) – the lowest level seen since December 2008. At the same time, the broad measure of labour underutilisation has also continued to moderate.^[4] Survey indicators have moderated somewhat from very high levels, but still point to continued employment growth in the second and third quarters of 2018. Signs of labour shortages have increased in some countries and sectors.

Rising household incomes supported growth in private consumption. Annual growth of households’ real disposable income increased from 1.5% in the final quarter of 2017 to 1.8% in the first quarter of 2018. Private consumption rose by 0.5%, quarter on quarter, in the first quarter of 2018, following a slower rate of increase in the final quarter of 2017. This outcome seems to reflect strong consumption growth of services, whereas goods consumption appears to have risen at a slower rate than in the fourth quarter of last year. On an annual basis, consumption rose by 1.5% in the first quarter of 2018, which represents a small improvement from the fourth quarter of last year when consumption rose by 1.4%. The annual rate of change in savings increased between the fourth quarter of 2017 and the first quarter of 2018. However, the saving ratio (expressed as a four-quarter moving average) remained broadly unchanged at 12.0% in the first quarter, only slightly above the record low of 11.9% in the third quarter of 2017.

Gains in employment are expected to continue to support robust growth in private consumption. While recent data on retail trade and new passenger car registrations point to continued, albeit relatively slower, growth in consumer spending in the second quarter of this year, other indicators support the picture of continued robust consumption dynamics. The latest survey results signal ongoing labour market improvements, which should continue to support aggregate income and thus consumer spending. A lower unemployment rate increases not only the income of those who find a new job, but also the expected future income of those who are already employed and face lower unemployment risk. Moreover, households’ net worth continued to increase at robust rates in the first quarter of 2018, thus lending further support to private consumption. Together, these factors explain why consumer confidence continues to stand at elevated levels close to the all-time high reached in May 2000. For a more comprehensive overview of recent consumption developments, see Article 3 in this issue of the Economic Bulletin.

While investment growth eased in the first quarter of 2018, short-term indicators continue to point to robust growth. The quarterly rise in investment in the first quarter of this year, of 0.3%, was brought about by an increase in construction investment of 1.3%, whereas non-construction investment declined by 0.5%. The decline in non-construction investment chiefly reflected the fall in investments in machinery and transport equipment. As regards the second quarter of 2018, short-term indicators point to continued, albeit slightly weakened, growth. For instance, monthly data on capital goods production stood on average in April and May 1.0% above the average level in the first quarter of 2018, when they declined by 2.1% on a quarterly basis. In addition, conditions in the capital goods sector, such as stabilising capacity utilisation and stable orders, as well as falling, but still strong, confidence and demand, signal continued growth in non-construction investment overall. With regard to construction investment, monthly construction production data until May point to continued – but moderating – growth in the second quarter of 2018. Survey data for the construction sector broadly support this picture.

Investment is expected to continue to grow at a robust pace. Investment continues to be supported by favourable earnings expectations, strong domestic and foreign demand, and accommodative financing conditions. According to the euro area sectoral accounts for the first quarter of 2018, business margins (measured as the ratio of net operating surplus to value added) remain close to the highest level since early 2009. Furthermore, earnings expectations for listed companies in the euro area, despite moderating somewhat, continue to support investment. At the same time, uncertainties surrounding the implementation of tariff increases may already be detrimental to investment decisions. As regards construction investment, the latest indicators point to a decelerating but still positive momentum in construction and housing investment. Households’ rising disposable income and very favourable lending conditions are expected to continue to underpin demand in the construction sector.

Euro area trade growth remained moderate at the beginning of the second quarter of 2018. Euro area nominal goods exports in April and May confirm the weak growth pace observed in the first quarter, decreasing by 0.6%, month on month, in May. Extra euro area goods exports decreased across almost all destinations; this was observed most notably in exports to the United Kingdom. Euro area nominal imports were up by 1.5%, month on month, in April and were stable in May. Survey indicators for global and euro area new manufacturing orders remained broadly stable in June and point to a continuing moderation of euro area exports for the coming quarter, while hard data such as new manufacturing orders outside the euro area showed signs of improvement in April and May.

Overall, the latest economic indicators suggest ongoing solid growth. Industrial production (excluding construction) displayed a relatively strong increase in May. Despite this, production stood on average in April and May 0.2% below the level seen in the first quarter of 2018, when it declined by 0.6% on a quarterly basis. More timely survey data signal ongoing robust growth, albeit at slower rates than in 2017. The composite output Purchasing Managers’ Index (PMI) averaged 54.7 in the second quarter of 2018, compared with 57.0 in the first quarter, before declining slightly in July 2018 to 54.3. Meanwhile, the European Commission’s Economic Sentiment Indicator (ESI) eased to 112.5 in the second quarter from 114.0 in the first quarter (see Chart 5). Both the ESI and the PMI continue to stand well above their respective long-term averages.

This easing reflects a pull-back from the high pace of growth observed last year and is related mainly to a weakening of external trade, compounded by an increase in uncertainty and some temporary and supply-side factors at both the domestic and the global level. Overall, however, growth is expected to remain solid and broad-based. The ECB’s monetary policy measures, which have facilitated the deleveraging process, should continue to underpin domestic demand. Private consumption is supported by ongoing employment gains (which, in turn, partly reflect past labour market reforms) and by growing household wealth. Business investment continues to strengthen on the back of very favourable financing conditions, rising corporate profitability and solid demand. Housing investment continues to improve. In addition, the broad-based global expansion, which is expected to continue, is providing impetus to euro area exports. The results of the latest round of the ECB Survey of Professional Forecasters, conducted in early July, show that private sector GDP growth forecasts were revised downwards for 2018 and 2019 compared with the previous round conducted in early April. The figure for 2020 remained unchanged.

The risks surrounding the euro area growth outlook can still be assessed as broadly balanced. Uncertainties related to global factors, notably the threat of protectionism, remain prominent. Moreover, the risk of persistent heightened financial market volatility continues to warrant monitoring.

Prices and costs

Euro area annual HICP inflation rose to 2.0% in June, up from 1.9% in May (see Chart 7). This increase reflected higher contributions from energy, food and non-energy industrial goods price inflation, which offset a lower contribution from services price inflation.

Measures of underlying inflation have remained generally muted but stand above earlier lows. HICP inflation excluding energy and food decreased to 0.9% in June from 1.1% in May. This was partly due to the lagged effects of the timing of Easter, which have contributed significantly to the volatile behaviour of this measure of inflation since March. Measures of underlying inflation that are more robust to Easter effects have remained broadly stable over recent months. For example, HICP inflation excluding energy, food and the volatile travel-related items and clothing was unchanged at 1.0% between March and May and down only slightly to 0.9% in June.

Price pressures for HICP non-energy industrial goods remained robust, with signs of more upward pressure visible in the early stages of the pricing chain. Producer price inflation for non-food consumer goods remained stable at 0.5% in May, unchanged since February 2018. Such resilience to downward pressure from the strong euro appreciation in 2017 may reflect the offsetting impact of strengthening domestic cost pressures, as well as stronger pricing power. There are also tentative signs of more upward pressures in the early stages of the pricing chain; for instance, growth in import prices for intermediate goods was 0.9% in May, up from -0.8% in April. Moreover, growth in the global Producer Price Index excluding energy has risen from its historical average in recent months. At the consumer level, HICP non-energy industrial goods inflation rose to 0.4% in June from 0.3% in May and April.

Recent wage growth data points to a continued upward shift from a trough in the second quarter of 2016. Growth in compensation per employee increased from 1.8% in the fourth quarter of 2017 to 2.0%^[5] in the first quarter of 2018, confirming the recent upward trend. Growth in negotiated wages increased from 1.5% in the fourth quarter of 2017 to 1.8% in the first quarter of 2018 and replaced wage drift^[6] as the main driver of the pick-up in actual wage growth. Looking ahead, recent wage agreements and the broadening of wage growth across sectors support the expectation of a further pick-up in wage growth. Overall, recent developments in wage growth follow the direction of improving labour market conditions, as other factors that have weighed on wage growth – including past low inflation and the ongoing impacts of labour market reforms implemented in some countries during the crisis – begin to fade. Rising wage growth is expected also to lead to upward pressures on prices (see the box entitled “The role of wages in the pick-up of inflation” in this issue of the Economic Bulletin).

Both market and survey-based measures of longer-term inflation expectations have remained broadly unchanged (see Chart 8). On 25 July the five-year forward inflation-linked swap rate five years ahead stood at 1.72%. The forward profile of market-based measures of inflation expectations continues to point to a gradual return to inflation levels below, but close to, 2%. These market-based measures continue to suggest that the risk of deflation remains well contained. The results of the ECB Survey of Professional Forecasters (SPF) for the third quarter of 2018 show average inflation expectations of 1.7% for each of 2018, 2019 and 2020. This represents upward revisions to 2018 and 2019, compared with the previous survey, attributable to oil price developments. According to the SPF, longer-term inflation expectations for the euro area remained stable at 1.9%.

Residential property prices in the euro area continued to accelerate further in the first quarter of 2018. According to the ECB’s residential property price indicator, the prices of houses and flats in the euro area increased by 4.1% year on year in the first quarter of 2018, up from 3.9% in the previous quarter, confirming a further strengthening and broadening of the house price cycle.

Money and credit

Broad money growth increased in June. The annual growth rate of M3 rose to 4.4%, from 4.0% in May, having gradually decelerated between its last peak (5.2%) in September 2017 and March 2018 (3.7%) (see Chart 9). The impact of the ECB’s monetary policy measures, solid economic growth and the low opportunity cost of holding the most liquid deposits continued to support growth. Accordingly, M1 remained the main driver of the expansion of M3, with an annual growth rate of 7.4% in June, after a significant 0.5 percentage point increase to 7.5% in May.

Broad money creation in the euro area appears to be gradually becoming more self-sustained. From a counterpart perspective, while the Eurosystem’s purchases of government securities under the public sector purchase programme remained the largest contributor to annual M3 growth, the contribution has declined (see the red portion of the bars in Chart 9). This reflects the reduction, from €60 billion to €30 billion in January 2018, in the Eurosystem’s net purchases under its asset purchase programme. The declining contribution to M3 growth from the Eurosystem’s asset purchases was offset by a moderate increase in the contribution from credit to the private sector since late 2017 (see the blue portion of the bars in Chart 9). This counterpart includes both monetary financial institution (MFI) loans to the private sector and MFI holdings of securities issued by the euro area private non-MFI sector. As such, it also covers the Eurosystem’s purchases of non-MFI debt securities under the corporate sector purchase programme. By contrast, government bond sales from euro area MFIs excluding the Eurosystem dampened M3 growth (see the light green portion of the bars in Chart 9). Finally, the annual contribution of the external sector remained marginally negative despite a monthly inflow in June, which likely reflected net purchases of euro area government bonds by non-euro area residents (see the yellow portion of the bars in Chart 9).

The recovery in loan growth is proceeding. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) rose to 3.5% in June, from 3.3% in May (see Chart 10). This was driven by loans to non-financial corporations (NFCs), the annual growth rate of which increased to 4.1%, from 3.7% in May. Meanwhile, the annual growth rate of loans to households was stable at 2.9%, where it has stood since December 2017. More specifically, the annual growth rate of loans to households for house purchase has remained moderate from a historical perspective. While growth in loans to households for house purchase, which is typically reported in net terms, has been dampened by loan repayments resulting from the boom period in mortgage markets before the financial crisis, the origination of new loans is stronger (see the box entitled “Developments in mortgage loan origination in the euro area” in this issue of the Economic Bulletin).

The recovery in loan growth has been supported by the significant decline in bank lending rates across the euro area since mid-2014 (notably owing to the ECB’s non‑standard monetary policy measures) and overall improvements in the supply of, and demand for, bank loans. In addition, banks have made progress in consolidating their balance sheets, although the level of non-performing loans (NPLs) remains high in some countries and may constrain financial intermediation.^[7]

The July 2018 euro area bank lending survey suggests that loan growth continued to be supported by easing credit standards and increasing demand across all loan categories in the second quarter of 2018. According to reporting banks, competitive pressure and reduced risk perceptions related to the ongoing solid economic growth and borrowers’ improved creditworthiness were important factors contributing to the net easing of credit standards. Banks also reported increasing net loan demand across all loan categories. The low general level of interest rates, inventories and working capital, merger and acquisition activity, favourable housing market prospects and consumer confidence were important drivers of loan demand. According to the results of a new question on the impact of NPL ratios on banks’ lending policies, euro area banks reported that they had contributed to a tightening of their credit standards and terms and conditions across all categories of loans over the past six months. The tightening impact has, however, generally diminished in comparison with the impact between 2014 and 2017 – in line with developments in actual NPLs – and is expected to decrease further in the next six months. Over the past six months, banks’ NPL ratios affected lending policies mainly through their impact on risk perceptions, risk tolerance and the cost of the balance sheet clean-up.

Bank lending rates for NFCs recorded a new historical low. In May 2018 the composite bank lending rate for loans to NFCs fell further to stand at a new historical low of 1.62%. In the same month, the composite bank lending rate for housing loans remained stable at 1.83%, slightly above its historical low of 1.78% recorded in December 2016 (see Chart 11). Composite bank lending rates for loans to NFCs and households have decreased significantly and by more than market reference rates since the ECB’s credit easing measures were announced in June 2014. The reduction in bank lending rates on loans to NFCs, as well as on loans to small firms (assuming that very small loans of up to €0.25 million are mainly granted to small firms), was particularly significant in those euro area countries that were most exposed to the financial crisis. This indicates a more uniform transmission of monetary policy to bank lending rates across euro area countries and firm sizes.

Net issuance of debt securities by euro area NFCs is estimated to have increased further in the second quarter of 2018. The latest ECB data indicate that, on a net basis, the total flow of debt securities issued by NFCs in April and May 2018 remained high and in line with the monthly levels recorded, on average, in the first quarter of the year (see Chart 12). Market data suggest a further strengthening of debt securities issuance in June 2018. Net issuance of listed shares by NFCs in April and May was positive and as high as the total flow of shares listed in the first quarter of 2018.

Financing costs for euro area NFCs are estimated to have decreased marginally in the second quarter of 2018. The overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, is estimated to have declined slightly to around 4.5% by the end of the second quarter of 2018 and somewhat further in July. The cost of financing now stands some 46 basis points above the historical low of July 2016, but it is still considerably below the levels observed in summer 2014. In the second quarter of 2018, the components of the cost of financing showed a slight decline in the cost of equity and a broadly stable cost of debt, expressed as the weighted average of the cost of bank lending and the cost of market-based debt. More recently, the estimated slight decline in the cost of financing in July 2018 is considered to reflect some moderation in both the cost of equity and – to a lesser extent – the cost of market-based debt.

Boxes

Imbalances in China: is growth in peril from a housing market downturn?

Prepared by Thomas Nielsen

The Chinese economy has recently been playing a key role in the global economic recovery. Recording growth rates of more than 6.5% over the past five years, China has contributed on average one-third of total global growth. It has also become one of the euro area’s largest trading partners, accounting for almost 7% of total extra-euro area exports. While the world economy has benefited from China’s economic strength and growing importance, a downturn would also have large repercussions for global activity. In fact, imbalances in China have been identified as a key external downside risk to the euro area and world economy.^[8] One catalyst for such a risk materialising could be the housing market.

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Cyclical developments in the euro area current account

Prepared by Michael Fidora

The euro area current account balance stood at the historically high level of 3.6% of GDP in the year up to the first quarter of 2018, slightly above the level of 3.5% of GDP recorded one year earlier (see Chart A). The slight increase in the current account surplus however masks significant decreases in the surplus on trade in goods (by 0.2 percentage point of GDP) as well as in the surplus on primary income (by 0.3 percentage point of GDP), which were slightly more than offset by an increase in the surplus on trade in services (by 0.5 percentage point of GDP).

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Growth synchronisation in euro area countries

By Jaime Martinez-Martin, Lorena Saiz and Grigor Stoevsky

The degree of business cycle synchronisation, both across the euro area countries as well as between the euro area and the rest of the world, is a pertinent research question. Regarding the euro area, the endogenous optimal currency area (OCA) hypothesis^[9] suggests that the degree of business cycle synchronisation among the participating countries should increase over time as a result of deepening financial and trade integration. Individual countries should thus become less exposed to idiosyncratic shocks, facilitating the effectiveness of the single monetary policy. Against this background, this box presents and analyses several measures of business cycle synchronisation both within the euro area as well as from a global perspective.

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The role of wages in the pick-up of inflation

Prepared by José Emilio Gumiel and Elke Hahn

In current forecasts and projections, a pick-up in labour costs is considered an important precondition for a sustained increase in underlying inflation. However, the signals provided by different labour cost indicators have been mixed for some time. While wage growth as measured by compensation per employee or by compensation per hour worked has clearly strengthened over the past two years, unit labour cost growth, i.e. wage growth adjusted for productivity growth, has remained rather flat over the same period (see Chart A). This begs the question: which labour cost indicators provide the relevant signal for the pass-through to, and the outlook for, underlying inflation? This box tries to shed some light on this issue by analysing the transmission of two different types of macroeconomic impulse, namely certain kinds of supply and demand shock, in the context of the New Area-Wide Model, and by comparing the results with the patterns of development observed in the recent past.^[10]

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Developments in mortgage loan origination in the euro area

Prepared by Ramón Adalid and Matteo Falagiarda

Loans to households for house purchase appear to have grown at a moderate rate in recent years, despite very favourable financing conditions, the recovery in economic activity and dynamic housing markets. ^[11] The annual growth rate of adjusted loans to households for house purchase was 2.8% in the first quarter of 2018, having increased gradually from slightly above 0% in 2014 (red line in Chart Aa). However, when assessing loan developments, it should be noted that loan growth figures are usually reported in net terms, i.e. newly originated loans and the repayments of previously granted loans are considered together because statistics on balance sheet items are derived from stock figures. Given the long-term nature of mortgage contracts, loan repayments have a long-lasting impact on net figures, especially after a boom, and thus obfuscate the prevailing lending dynamics. Against this background, this box presents the results of a simulated portfolio approach which decomposes net lending flows into loan origination and the repayments of previously granted outstanding loans. Examining these two components separately provides a better view of current loan developments.^[12]

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Country-specific recommendations for economic policies under the 2018 European Semester

Prepared by João Capella-Ramos

Within the EU governance framework for the coordination of economic policies, the country-specific recommendations (CSRs) represent an integral part of the annual European Semester process. They provide guidance to individual EU Member States on how to address structural reform needs and macroeconomic imbalances in the following 12-18 months. CSRs are the instrument through which EU national economic policies are treated as a matter of common concern and coordinated within the Council of the European Union in accordance with Article 121 of the Treaty on the Functioning of the European Union. They therefore constitute a cornerstone of the EU’s macroeconomic imbalance procedure (MIP), whose aim is to prevent, detect and correct macroeconomic imbalances in individual countries, thereby containing risks to the smooth functioning of Economic and Monetary Union (EMU). Their timely and proper implementation is critical to reducing vulnerabilities and strengthening the economic resilience of the euro area and the EU as a whole, ultimately leading to higher growth potential in the long term.^[13] Against the background of the 2018 CSRs received by 27 EU Member States (i.e. all excluding Greece^[14]), this box examines the policy recommendations addressed to 18 euro area countries, with the exception of those that pertain strictly to the implementation of the EU’s Stability and Growth Pact.^[15]

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Articles

The evolution of the ECB’s accountability practices during the crisis

Prepared by Nicolò Fraccaroli, Alessandro Giovannini and Jean‑François Jamet

This article examines the evolution of the ECB’s accountability practices during the financial crisis. After describing the challenges stemming from the crisis and changes resulting from the conferral of new supervisory tasks on the ECB, it provides evidence on how the strengthening of the ECB’s accountability has taken shape in the context of its relationship with the European Parliament in line with the latter’s key role as provided for in the Treaties. The ECB and the European Parliament, building on the accountability framework enshrined in primary law, have increased the frequency of their interactions, made innovations regarding the format and sharpened the focus of their exchanges, allowing increased scrutiny of the ECB’s policies. This has provided the ECB with more opportunities to explain its decisions and demonstrate that it is acting in accordance with its democratic mandate, which is a fundamental pillar of its legitimacy.

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Measuring fragmentation in the euro area unsecured overnight interbank money market: a monetary policy transmission approach

Prepared by Jens Eisenschmidt, Danielle Kedan and Robin Tietz

The overnight money market plays an important role in the implementation and transmission of monetary policy in the euro area. Money market fragmentation is a sign of impairment in the transmission mechanism which merits the close monitoring of a set of suitable indicators. This article discusses concepts and measurement of fragmentation and proposes a new measure of fragmentation from a monetary policy transmission perspective.

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Private consumption and its drivers in the current economic expansion

Prepared by Maarten Dossche, Magnus Forsells, Luca Rossi and Grigor Stoevsky

This article documents the key role that private consumption has played in recent output growth (2013‑18), and asks how long the current growth in consumption can continue and whether it is self-sustaining. To that end, this article tries to identify the relative importance of different factors driving consumption, such as the recovery in the labour market, accommodative monetary policy, the 2014‑15 drop in oil prices, the increase in asset prices, the easing of credit conditions and deleveraging. As the fall in consumption from 2008 to 2013 was very heterogeneous across countries, this article also sheds light on the extent to which the current expansion has actually led to a net increase in consumption over the past decade. This is relevant because private consumption is also a prime indicator of the economic well-being of households.

While the growth of consumption has been low compared with previous expansions, since 2013 it has exceeded initial expectations. It has been driven mainly by the recovery in the labour market, even though unemployment in some countries and for some groups of workers remains higher than before 2008. Looking forward, as labour markets continue to improve, private consumption should expand further in all countries and for all groups of workers. Through its impact on the labour market, the ECB’s accommodative monetary policy is not only contributing to the expansion of private consumption, but also to a decrease in inequality. At the same time, there is little evidence that low interest rates have led to generalised increases in household indebtedness, supporting the sustainability of the overall economic expansion.

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Statistics

http://www.ecb.europa.eu/pub/pdf/ecbu/ecb.eb_annex201805.en.pdf