Economic and monetary developments

Overview

Based on the assessment of the economic and inflation outlook for the euro area, also taking into account the latest Eurosystem staff macroeconomic projections, the Governing Council decided at its monetary policy meeting on 12 December to keep the key ECB interest rates unchanged and to reiterate its forward guidance on policy rates, net asset purchases and reinvestments. Incoming information since the last Governing Council meeting in late October points to continued muted inflation pressures and weak euro area growth dynamics, although there are some initial signs of stabilisation in the growth slowdown and of a mild increase in underlying inflation in line with previous expectations. Ongoing employment growth and increasing wages continue to underpin the resilience of the euro area economy. Against this overall background and in the light of the subdued inflation outlook, the Governing Council reiterated the need for monetary policy to remain highly accommodative for a prolonged period of time to support underlying inflation pressures and headline inflation developments over the medium term. In addition, the Governing Council’s forward guidance ensures that financial conditions adjust in accordance with changes to the inflation outlook. In any event, the Governing Council continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aims in a sustained manner, in line with its commitment to symmetry.

Economic and monetary assessment at the time of the Governing Council meeting of 12 December 2019

Global real GDP growth (excluding the euro area) weakened during the first half of 2019, but signs of stabilisation started to emerge towards the end of the year. The weak growth momentum was characterised by slowing growth in both manufacturing and investment, which have been reinforced by rising policy and political uncertainty particularly amid escalating trade tensions and Brexit-related developments. More recent information, however, points to a stabilisation in global growth, as confirmed also by survey-based data. In particular, the Purchasing Managers’ Indices (PMI) point to a moderate recovery in manufacturing output growth and some moderation in services output growth. Looking ahead, the recovery in global economic activity is projected to be shallow, reflecting a moderation of growth in advanced economies and a sluggish recovery in some emerging economies. Global trade softened this year and is projected to expand at a slower pace than global activity in the medium term. Global inflationary pressures remain contained, and the balance of risks to global economic activity continues to be tilted to the downside, although risks are becoming less pronounced.

Since the Governing Council meeting in September 2019 euro area long-term risk-free rates have increased and the forward curve of the euro overnight index average (EONIA) has shifted upwards, with markets currently expecting no further cut in the deposit facility rate. In line with an improvement in global risk sentiment, euro area equity prices have increased and corporate spreads have tightened. Euro area long-term sovereign yields also largely reflect the rise in risk-free rates. In foreign exchange markets, the euro remained broadly stable in trade-weighted terms.

Euro area real GDP growth was confirmed at 0.2%, quarter on quarter, in the third quarter of 2019, unchanged from the previous quarter. The ongoing weakness of international trade in an environment of persistent global uncertainties continues to weigh on the euro area manufacturing sector and is dampening investment growth. At the same time, incoming economic data and survey information, while remaining weak overall, point to some stabilisation in the slowdown of economic growth in the euro area. The services and construction sectors remain resilient, despite some moderation in the latter half of 2019. Looking ahead, the euro area expansion will continue to be supported by favourable financing conditions, further employment gains in conjunction with rising wages, the mildly expansionary euro area fiscal stance and the ongoing – albeit somewhat slower – growth in global activity.

This assessment is broadly reflected in the December 2019 Eurosystem staff macroeconomic projections for the euro area. These projections foresee annual real GDP increasing by 1.2% in 2019, 1.1% in 2020 and 1.4% in both 2021 and 2022. Compared with the September 2019 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised down slightly for 2020. The risks surrounding the euro area growth outlook, related to geopolitical factors, rising protectionism and vulnerabilities in emerging markets, remain tilted to the downside, but have become somewhat less pronounced.

According to Eurostat’s flash estimate, euro area annual HICP inflation increased from 0.7% in October 2019 to 1.0% in November, reflecting mainly higher services and food price inflation. On the basis of current futures prices for oil, headline inflation is likely to rise somewhat in the coming months. Indicators of inflation expectations stand at low levels. Measures of underlying inflation have remained generally muted, although there are some indications of a mild increase in line with previous expectations. While labour cost pressures have strengthened amid tighter labour markets, the weaker growth momentum is delaying their pass-through to inflation. Over the medium term, inflation is expected to increase, supported by the Governing Council’s monetary policy measures, the ongoing economic expansion and solid wage growth.

This assessment is also broadly reflected in the December 2019 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.2% in 2019, 1.1% in 2020, 1.4% in 2021 and 1.6% in 2022. Compared with the September 2019 ECB staff macroeconomic projections, the outlook for HICP inflation has been revised up slightly for 2020 and down slightly for 2021, mainly driven by the expected future path of energy prices. Annual HICP inflation excluding energy and food is expected to be 1.0% in 2019, 1.3% in 2020, 1.4% in 2021 and 1.6% in 2022.

In October 2019 the annual growth of broad money remained robust, while lending to the private sector continued its gradual recovery. Broad money (M3) growth stood at 5.6% in October 2019, unchanged from the previous month. Sustained rates of broad money growth reflect ongoing bank credit creation for the private sector and low opportunity costs of holding M3. At the same time, favourable bank funding and lending conditions continued to support loan flows and thereby economic growth. The annual growth rate of loans to non-financial corporations increased to 3.8% in October, up from 3.6% in September. The Governing Council’s accommodative monetary policy stance will help to safeguard very favourable bank lending conditions and will continue to support access to financing, across all economic sectors and in particular for small and medium-sized enterprises.

The aggregate fiscal stance for the euro area is expected to remain mildly expansionary in 2020, thus providing support to economic activity. The stance is expected to remain expansionary in 2021 and to stabilise in 2022, mainly on account of a declining but still positive primary balance. In view of the weakening economic outlook, governments with fiscal space should be ready to act in an effective and timely manner. In countries where public debt is high, governments need to pursue prudent policies and meet structural balance targets, which will create the conditions for automatic stabilisers to operate freely. All countries should intensify their efforts to achieve a more growth-friendly composition of public finances.

Monetary policy decisions

Based on the regular economic and monetary analyses, the Governing Council decided at its monetary policy meeting on 12 December to keep the key ECB interest rates unchanged and to reiterate its forward guidance on policy rates, net asset purchases and reinvestments:

• First, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.
• Second, after restarting net purchases under the ECB’s asset purchase programme (APP) at a monthly pace of €20 billion on 1 November, the Governing Council expects them to run for as long as necessary to reinforce the accommodative impact of the key ECB interest rates, and to end shortly before it starts raising those rates.
• Third, the Governing Council intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

The comprehensive package of policy measures that the Governing Council decided in September provides substantial monetary stimulus, which ensures favourable financing conditions for all sectors of the economy. In particular, easier borrowing conditions for firms and households are underpinning consumer spending and business investment. This will support the euro area expansion, the ongoing build-up of domestic price pressures and, thus, the robust convergence of inflation to the Governing Council’s medium-term aim. Looking ahead, the Governing Council will closely monitor inflation developments and the impact of the unfolding monetary policy measures on the economy. The Governing Council continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner, in line with its commitment to symmetry.

External environment

While global real GDP growth (excluding the euro area) weakened during the first half of 2019, the latest available data point to a stabilisation in the second half. The weak growth momentum was characterised by slowing growth in both manufacturing and investment, which have been reinforced by rising policy and political uncertainty particularly amid escalating trade tensions and Brexit-related developments. More recent data, however, point to a stabilisation in global growth in the third quarter, as also confirmed by recent survey-based data. In particular, the Purchasing Managers’ Indices (PMI) point to a moderate recovery in manufacturing output growth and some moderation in services output growth. Looking ahead, the recovery in global economic activity is projected to be shallow, reflecting a moderation of growth in advanced economies and a sluggish recovery in emerging economies. Global trade softened this year and is projected to expand at a slower pace than global activity in the medium term. Global inflationary pressures remain contained, while the balance of risks to global economic activity, although less pronounced, remains tilted to the downside.

Global economic activity and trade

While global growth (excluding the euro area) weakened during the first half of the year, signs of stabilisation started to emerge towards the year-end. After having peaked in mid‑2018, global growth entered a period of weakness which continued into the first half of 2019, marking the weakest period of growth momentum since the global financial crisis. The slowdown has been characterised by weakness in both global manufacturing activity and investment, exacerbated by increasing policy uncertainty amid recurring escalations of trade tensions^[1] and Brexit-related developments. Recent data, however, point to a stabilisation in global activity, though at low levels. Real GDP continued to expand steadily in the United States and Japan, while real activity growth rebounded in the United Kingdom. In the United States, in the third quarter, a strong labour market and consumer spending, and favourable financial conditions remained supportive of growth, while in Japan solid domestic demand was the main engine of growth. In the United Kingdom, growth rebounded on the back of unexpectedly strong net export growth, and solid growth in private consumption. In China, third quarter data confirmed the gradual slowdown in activity, driven by slowing investment, while growth has stabilised across other EMEs.

Survey-based indicators suggest that the stabilisation of global activity has continued in the fourth quarter. The global composite output Purchasing Managers’ Index (PMI) excluding the euro area was unchanged in the third quarter compared to the previous quarter, pointing to a stabilisation in global activity. Available data for October and November confirm steady, albeit subdued, global GDP growth (excluding the euro area) in the fourth quarter. At a sectoral level, since July/August the gap between the manufacturing and services output PMIs at the global level has progressively narrowed, pointing to a gradual recovery in manufacturing output growth and some moderation in services output growth.

Global financial conditions have eased further. Since the finalisation of the September 2019 ECB staff macroeconomic projections, financial conditions have eased in both advanced and emerging economies. In emerging markets, the improvement in financial conditions is mainly accounted for by the fall in bond yields and the compression of spreads. Advanced economies, on the other hand, have benefited from higher stock valuations (in particular in the United States and the United Kingdom) and the tightening of corporate spreads. An easing of trade tensions, lower Brexit-related uncertainty and further monetary accommodation have contributed to these developments.

Looking ahead, only a mild pick-up in global growth is projected, reflecting a deceleration of growth in advanced economies and China, which is offset by a moderate recovery in EMEs. Developments in global growth are shaped by three main forces. A slowing cyclical momentum in most advanced economies and the gradual transition of China to a lower growth path will weigh on global growth. Conversely, a favourable base effect due to a stabilisation of activity in those EMEs that experienced a (severe) recession will contribute to the recovery. Compared to the September 2019 macroeconomic projection exercise, the global growth outlook is revised down over the projection horizon, reflecting a less dynamic than previously expected recovery in some EMEs, including in the light of domestic instability in some of them (e.g. Hong Kong and Chile).

Economic activity is expected to remain resilient in the United States in the near term, and to decelerate in the medium term. Activity expanded at 2.1% in annualised terms in the third quarter of 2019, broadly unchanged from the second quarter. A strong labour market, resilient consumer spending and supportive financial conditions remained the main drivers of growth, while non-residential investment continued to contract. The net trade contribution was neutral, with both imports and exports growing modestly. Annual headline consumer price inflation picked up marginally to 1.8% in October, from 1.7% in the previous month, largely on account of food and energy prices. Consumer price inflation excluding food and energy fell slightly in October to 2.3%. Over the medium term, growth is projected to gradually return to the potential growth rate of just below 2%, reflecting a maturing economic cycle and increasingly binding capacity constraints, while consumer price inflation is expected to remain above 2%.

In China, economic activity remains on a gradually slowing trajectory. In the third quarter of 2019 annual GDP growth slowed to 6.0% from 6.2% in the second quarter, driven by less supportive net trade. Investment surprised on the downside and is expected to remain weak, while the trade conflict with the United States continues to weigh on trade. Looking ahead, growth is projected to decrease further in 2020, reflecting slower exports and weak investment, and to marginally pick up in 2021 and 2022, supported by policy actions. Overall, the deceleration in economic activity reflects the past deleveraging efforts aimed at containing financial risks, the government’s focus on rebalancing the economy away from investment and the impact of the ongoing trade tensions with the United States. Implementation of structural reforms is projected to result in an orderly transition to a more moderate growth path that is less dependent on investment and exports.

Economic activity remains muted in Japan and is projected to grow moderately over the medium term. Real GDP grew by 0.4% in the third quarter of 2019 (quarter on quarter), compared to 0.5% in the previous quarter. Solid domestic demand, supported by firms’ private non-residential investment and frontloaded spending ahead of the 1 October value-added tax hike, was partially offset by weak exports and inventory adjustments as well as some payback for the relatively strong outcome in the second quarter (partly as a result of the extended holiday period to celebrate the Imperial succession). While growth is projected to temporarily weaken following the value-added tax hike and the natural disasters in October, activity is expected to gradually return to a moderate growth path as Japan continues to benefit from a highly accommodative monetary policy, robust labour market conditions and the preparations for the Tokyo 2020 Olympics. The recent announcement of a significant fiscal stimulus package by the Japanese government – still to be approved by parliament – is also likely to provide support to growth further ahead. At the same time, a maturing business cycle, amid increasingly binding labour and capacity constraints, is expected to limit the pace of growth.

Real GDP growth recovered modestly in the third quarter in the United Kingdom, but the outlook remains subdued, despite a reduced risk of a disorderly Brexit. After contracting in the second quarter (-0.2% quarter on quarter), real GDP expanded by 0.3% in the third, boosted by unexpectedly strong net export growth. Growth in private consumption remained solid (0.4% quarter on quarter), reflecting stronger real wage growth over the course of 2019, with further support from government consumption (0.3% quarter on quarter), while investment and inventories continued to be a drag on growth. Brexit-related uncertainty remained high, constraining growth over the short term. Longer-term growth prospects remain heavily dependent on the nature of the eventual post-Brexit trading arrangements still to be agreed between the United Kingdom and the EU. Inflation declined strongly at the start of the fourth quarter, with UK annual CPI inflation falling to 1.5% in October, down from 1.8% in the third quarter. The fall reflects the impact of lower sterling-denominated oil prices compared with last year, lower import prices owing to the appreciation of the pound sterling since September, and a strong downward impact on domestic energy prices as a result of the decrease in the regulator’s energy price cap, which is likely to be reversed in the spring of 2020.

Real GDP growth is projected to remain buoyant in central and eastern European countries over the projection horizon. Economic activity continues to be supported by solid consumer spending, underpinned by tight labour markets, while investment is forecast to soften against the backdrop of a more advanced phase of the EU funds cycle. Over the projection horizon, growth is expected to moderate from above-potential rates, albeit remaining robust.

Economic activity in large commodity-exporting countries is projected to rebound modestly from the weakness experienced in the course of 2019. In Russia, the feed-in of contaminated oil into a key export pipeline led to large-scale disruptions, but a quicker than anticipated restoration of output resulted in better than expected GDP and export outcomes in the third quarter of 2019. Going forward, the medium-term outlook will be shaped primarily by fiscal and structural policy implementation, global oil market developments, specifically the commitment by the OPEC+ group of major oil producers to sustain oil production cuts, and the scope of the international sanctions regime under which Russia will be operating. In Brazil, despite some improvements since early 2019, growth remains fragile owing to a tight fiscal situation (including budget freezes), an uncertain external environment (e.g. trade tensions and crises in Argentina and other Latin American countries) and idiosyncratic shocks (e.g. a dam collapse in the country). While the recently approved pension reform was critical in boosting confidence, the degree to which additional necessary fiscal reforms are implemented will significantly influence growth in the medium-to-long term.

In Turkey, growth is projected to remain mildly positive in 2019, before gradually recovering in the medium term. Following the sharp contraction in GDP in the second half of 2018, the economy rebounded in the first half of 2019 owing to fiscal stimulus ahead of the local elections in March, stronger household consumption and net exports, while investment continued to contract. Growth is expected to remain mildly positive in 2019, assuming continued resilience in household consumption, while the external environment could be somewhat less supportive. Economic activity is expected to gradually accelerate towards the end of the projection horizon.

Global trade has declined significantly in the course of 2019 amid recurring escalations of trade tensions and slowing industrial activity. After contracting in the first half of 2019, the latest available data point to a stabilisation in global trade for the rest of the year, though at very subdued levels. Across advanced economies, trade returned to moderate growth in the third and fourth quarters of 2019, supported by a normalisation of imports in the United Kingdom (after the exceptional stock building at the start of 2019)^[2] and a pick-up in imports in central and eastern European EU countries, following a temporary slowdown in the second quarter. Across EMEs, trade continued to contract in the third quarter owing to trade headwinds in China, the economic slowdown in India and political turbulence in Latin America, but there are signs of stabilisation in the fourth quarter. According to CPB data, global merchandise imports (excluding the euro area) increased by 0.8% in the third quarter of 2019, relative to the second quarter, after three consecutive quarters of contraction and despite the sharp monthly fall in September (see Chart 2). As survey indicators on new export orders continue to remain in contractionary territory, despite some mild pick-up, the current weakness in global trade is likely to continue in the near term.

Recent developments in the US trade policy stance provide mixed signals about a potential dissipation of trade tensions. The resumption of the US‑China bilateral trade negotiations in early October paved the way for a “Phase 1” trade deal, triggering hopes of some de-escalation of the trade conflict. However, at the cut-off date for this commentary, trade talks continued amid political skirmishes between the two countries and it remained unclear by when a trade deal could be signed.^[3] In view of this progress, the United States has delayed indefinitely its 15 October tariff hike.^[4] Furthermore, a US decision on whether to impose tariffs on EU car (and car part) imports (initially due by mid-November) has been postponed. However, trade tensions have recently escalated vis-à-vis other countries. In early December the US administration threatened to reinstate tariffs on imports of steel and aluminium from Argentina and Brazil in response to their currency policies. At the same time, following the conclusion of an investigation initiated by the US Trade Representative into the Digital Services Tax enacted by France in 2019, the United States has threatened to impose tariffs on selected imports of French products, as this tax was found to be discriminating against US companies. While the overall volume of trade potentially affected by these tariffs is not large, these recent escalations do not bode well for a potential dissipation of trade tensions.

Global imports are projected to increase gradually over the medium term, and to expand at a more subdued pace than global activity. The further escalation of trade tensions, the effects of which will continue to be felt into 2020, coupled with a more gradual than previously projected recovery in emerging economies and the structural rebalancing of the Chinese economy, will contribute to a delay in the recovery in trade. As a result, the elasticity of trade to economic activity is projected to remain below the unit value over the projection horizon. According to the December 2019 Eurosystem staff macroeconomic projections, global imports (excluding the euro area) are expected to decelerate markedly from 4.6% growth in 2018 to zero growth in 2019, before recovering to 0.8% in 2020, 2.4% in 2021 and 2.7% in 2022. Euro area foreign demand, which expanded by 3.7% last year, is expected to slow down to 0.7% in 2019, before increasing gradually to 1.0% in 2020, 2.3% in 2021 and 2.6% in 2022. Compared to the September 2019 ECB staff macroeconomic projections, euro area foreign demand has been revised down by 0.3 percentage points in 2019, 0.9 percentage points in 2020 and 0.4 percentage points in 2021. In addition to the impact of the tariffs announced at the end of August and weaker data outturns, these revisions also reflect a broad-based weakness in import momentum across both advanced and emerging economies on the back of a subdued growth outlook.

The balance of risks to global activity remains tilted to the downside, but risks have become somewhat less pronounced. A further escalation of trade disputes would be detrimental to global trade and growth and cause disruptions to global supply chains. Moreover, a “no deal” Brexit scenario could have more adverse spillover effects, especially in Europe. A sharper slowdown in China’s economy could be harder to counteract with effective policy stimuli and might prove a challenge to the ongoing rebalancing process in China. Repricing in financial markets might dent risk appetite globally, while a further escalation of geopolitical tensions could also adversely affect global activity and trade. Upside risks concern a swifter recovery in global trade and a more benign resolution of current political uncertainties.

Global price developments

Oil prices have increased amid improving market sentiment. Concerns about weak global oil demand remained a predominant market force until mid-October when US‑China trade talks resumed. Since then oil prices have recovered on the back of more buoyant market sentiment, and have been further supported by the agreement by OPEC+ on 6 December to implement more substantial production cuts.

In the December 2019 Eurosystem staff macroeconomic projections, oil prices are foreseen to decline over the projection horizon. Owing to the increase in spot prices, the oil futures curve has moved slightly above the one in the September 2019 ECB staff macroeconomic projections, while the slope is broadly unchanged. Consequently, the oil price assumptions underpinning the December 2019 Eurosystem staff macroeconomic projections were around 2.1%, 4.6% and 2.1% higher for 2019, 2020 and 2021, respectively, than the assumptions underpinning the September 2019 ECB staff macroeconomic projections. Since the cut-off date for the December projections, the price of oil has increased further, with Brent crude standing at USD 65.2 per barrel on 11 December.

Global inflationary pressures remain muted. In countries belonging to the Organisation for Economic Co-operation and Development (OECD), annual headline consumer price inflation was 1.6% in October 2019, unchanged from the previous month. Energy prices continued to be a drag on headline inflation (falling further to ‑3.0% from ‑2.7% in September), while food price inflation picked up marginally, thereby offsetting the fall in energy prices. Annual CPI inflation excluding food and energy decreased slightly to 2.0% from 2.1% in September (see Chart 3). Inflationary pressures remain muted across major advanced economies, despite the easing stance of monetary policy and tight labour market conditions, which are failing to fully pass through to wage increases. Overall, this suggests that underlying inflationary pressures are likely to remain subdued for the foreseeable future.

Looking ahead, global inflationary pressures are expected to remain contained. Growth in the euro area’s competitors’ export prices (in national currency) is expected to broadly stabilise over the medium term, as the contribution from a downward sloping oil price futures curve is expected to be broadly offset by the depreciation of the euro over the projection horizon.

Financial developments

Since the Governing Council’s meeting in September 2019 euro area long-term risk-free rates have increased and the forward curve of the euro overnight index average (EONIA) has shifted upwards, with markets currently expecting no further cut in the deposit facility rate. In line with some improvement in global risk sentiment, euro area equity prices have increased and corporate spreads have tightened. As euro area sovereign yields have largely reflected the rise in risk-free rates, sovereign spreads have shown little change; only Italy’s spread has risen significantly, mainly on account of domestic political tensions. In foreign exchange markets, the euro has remained broadly stable in trade-weighted terms.

Long-term sovereign yields have increased across the euro area, indicating a turnaround of the downward trend seen from late 2018 until August 2019 (see Chart 4). During the period under review (12 September to 11 December 2019) the GDP-weighted euro area ten-year sovereign bond yield increased by 25 basis points to 0.20% as risk-free rates rose amid an improvement in risk sentiment and a tentative stabilisation of the macroeconomic outlook. The ten-year sovereign bond yield in the United Kingdom also increased over the review period, to around 0.78%, while the equivalent yield in the United States remained roughly unchanged at 1.79%.

Euro area sovereign bond yields largely reflected the rise in the risk-free overnight index swap (OIS) rate in the period under review, such that most spreads to the OIS – other than for Italy – remained broadly unchanged (see Chart 5). A sizeable increase of 27 basis points to 1.43 percentage points was observed for the spread on ten-year Italian sovereign bonds, which mainly reflected increased domestic political tensions and hence had no spillover effects on other euro area countries. The corresponding spreads for Germany and Portugal narrowed by 3 and 4 basis points respectively to ‑0.23 and 0.46 percentage points, while those for Spain and France widened by 7 and 1 basis points to 0.53 and 0.09 percentage points. Overall, the GDP-weighted spread for the euro area increased by 6 basis points to 0.27 percentage points.

The EONIA and the new benchmark euro short-term rate (€STR) stood on average over the review period at ‑45 basis points and ‑54 basis points respectively. Both rates were around 10 basis points lower than the average levels recorded in August 2019, reflecting the cut in the deposit facility rate which took effect on 18 September 2019. The methodology for computing the EONIA changed on 2 October 2019; it is now calculated as the €STR plus a fixed spread of 8.5 basis points.^[5] Excess liquidity increased in the period under review by approximately €41 billion to around €1,800 billion, reflecting mainly a decrease in liquidity-absorbing autonomous factors and the restart of Eurosystem net asset purchases on 1 November 2019.

The EONIA forward curve has shifted considerably upwards, indicating that markets no longer expect a further deposit facility rate cut (see Chart 6). Having almost entirely lost its inverted shape in the review period, the curve reaches a low of around ‑0.49% at the turn of the year from 2020 to 2021, i.e. just a few basis points below the current level of the EONIA. The vanishing inversion of the EONIA forward curve indicates that markets no longer expect a further cut in the deposit facility rate. Overall, the curve remains below zero for horizons up to 2025, reflecting continued market expectations of a prolonged period of negative interest rates.

Broad indices of euro area equity prices have risen on the back of an improvement in global risk sentiment (see Chart 7). Over the review period equity prices of euro area financial and non-financial corporations (NFCs) increased by 6.6% and 3.0% respectively. The drag on equity prices stemming from higher risk-free rates and somewhat lower longer-term earnings expectations was more than offset by a reduction in the equity risk premium, which may partly reflect some relaxation of global trade tensions and a tentative stabilisation of the macroeconomic outlook.

Financial and non-financial corporate bond spreads in the euro area decreased over the review period (see Chart 8). As the improvement in global risk sentiment proved supportive for risk assets in general, the gains in equity prices were mirrored by a tightening of corporate bond yield spreads in the euro area. Spreads on both investment-grade NFC bonds and financial sector bonds relative to the risk-free rate came down 11 and 13 basis points respectively in the review period to stand at 61 and 73 basis points. The decline in spreads did not reflect changes in credit fundamentals, as measured by ratings and expected default frequencies, which remained broadly unchanged. Overall, although corporate bond spreads are currently above the lows reached in early 2018, they remain considerably below the levels observed in March 2016, prior to the announcement and subsequent launch of the corporate sector purchase programme.

In foreign exchange markets, the euro remained broadly stable in trade-weighted terms (see Chart 9), with some bilateral exchange rates moving in opposite directions. The nominal effective exchange rate of the euro, as measured against the currencies of 38 of the euro area’s most important trading partners, depreciated by 0.1% over the review period. The euro strengthened against major currencies, including the US dollar (by 1.0%), the Chinese renminbi (by 0.3%), the Japanese yen (by 1.9%) and the Swiss franc (by 0.2%). The euro also appreciated vis-à-vis the currencies of Brazil, India and Turkey. This development was offset mainly by a fall in the euro of 5.3% against the pound sterling amid news pointing to an increased likelihood of a smooth Brexit. The euro also depreciated against the Czech koruna (by 1.2%) and the Polish zloty (by 1.0%).

Economic activity

Euro area real GDP growth remained at 0.2%, quarter on quarter, in the third quarter of 2019. Economic activity in the euro area was supported primarily by private consumption, which continued to underpin the positive contribution to growth provided by domestic demand. In turn, the external sector continued to weigh on euro area growth, as reflected in the slight negative contribution from net trade. Looking ahead, incoming information suggests moderate growth, albeit with some downside risks. The December 2019 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 1.2% in 2019, 1.1% in 2020 and 1.4% in both 2021 and 2022. Compared with the September 2019 projections, real GDP growth has been revised down by 0.1 percentage points in 2020, given sizeable downward revisions to foreign demand which are only partially offset by more supportive fiscal and monetary policies and an effective depreciation of the euro.

Growth in the euro area continued at a moderate pace in the third quarter of 2019, supported by resilient domestic demand. Real GDP increased by 0.2%, quarter on quarter, in the third quarter of this year, unchanged compared with the previous quarter and below the 0.4% seen in the first quarter of the year (see Chart 10). Domestic demand continued to make a positive contribution to growth in the third quarter of 2019, while changes in inventories contributed negatively. Developments in the external sector continued to weigh on euro area growth, as reflected by a slight negative contribution from net trade. On the production side, economic activity in the third quarter was mainly supported by growth in services and a rebound was seen in the construction sector, while value added in industry (excluding construction) contracted further.

The labour market continued to improve, but at a moderate pace (see Chart 11). Employment increased by 0.1% in the third quarter of 2019, down from 0.2% in the second quarter. This moderate increase was broad-based across sectors and countries. The level of employment currently stands 3.9% above the pre-crisis peak recorded in the first quarter of 2008. The unemployment rate was unchanged at 7.6% in the third quarter. It has since declined to 7.5% in October and remains near pre-crisis low levels. Productivity per person employed increased by 0.1%, quarter on quarter, in the third quarter of 2019. Looking ahead, survey indicators suggest that near-term employment growth will continue to be positive. Box 4 describes a principal component analysis of the labour market and shows that labour market momentum remains elevated, although declining somewhat, suggesting further moderate improvements in the labour market in the near term.

Private consumption continues to be supported by higher labour income and stronger household balance sheets. Private consumption rose by 0.5%, quarter on quarter, in the third quarter of 2019, following somewhat weaker growth in the second quarter. Retail sales during the third quarter of 2019 were on average 0.5% above their level in the second quarter, when they also rose by 0.6% on a quarterly basis. However, in October retail sales edged down by ‑0.6%, compared to the previous month. From a medium-term perspective, increasing labour income continues to support the underlying momentum in consumer spending. In addition, the continued strengthening of households’ balance sheets remains an important factor behind steady consumption growth.

Business investment (proxied by non-construction investment) increased slightly by 0.2%, quarter on quarter, in the third quarter of 2019, following a significant increase in the previous quarter driven by investment in intellectual property in Ireland. Incoming data suggest subdued business investment growth in the euro area. Confidence in capital goods manufacturing stabilised somewhat in November, although it continued to decline in quarterly average terms, against the backdrop of global uncertainty coupled with a number of structural factors – such as environmental regulations and technological change – also contributing. Declining levels of capacity utilisation in the manufacturing sector, together with weak firm profit margins and earnings expectations, also point to muted investment growth. On a positive note, business investment will continue to be supported by favourable financing conditions.

Housing investment increased by 0.6% in the third quarter of 2019, following a modest increase by 0.1% in the second quarter. Supported by both its residential and non-residential components, construction investment also grew by 0.3% in the third quarter. Despite the continuing recovery in the housing sector, short-term and survey indicators suggested diverging developments in housing markets. On the one hand, demand-side indicators – such as an increase in consumers’ spending intentions as regards new or existing housing – point to buoyant dynamics. On the other hand, supply-side indicators – such as construction production, building permits and reports by construction companies of labour shortages – hint at increasingly binding constraints to production. The positive, but decelerating, momentum in housing investment is expected to continue in the fourth quarter. In October and November, confidence indicators, although still above historical averages, declined, while the PMI for housing averaged 50.7, edging up from 50.1 in the third quarter.

Total real euro area exports continued to expand at a slow pace in the third quarter of 2019 (0.4% from 0.3% in the second quarter in quarter-on-quarter terms). Euro area exports of goods recovered while exports of services softened, amid some normalisation of exports to the United Kingdom and Turkey. Exports to the United States continued to expand, offsetting negative dynamics to other destinations – especially to Asia. Net trade contribution to GDP growth was marginally negative (-0.1 pp). Looking ahead, leading indicators suggest that trade conditions are stabilising around weak dynamics. Early indications of a bottoming out in the fourth quarter can be concluded from less negative export orders while shipping indicators return a mixed picture. International trade policy conditions are also having a negative impact on recent trade developments as manufacturing is organised around a deeply integrated regional network that makes the euro area particularly fragile to rising protectionist measures (see Box 1 entitled “The effects of tariff hikes in a world of global value chains”).

The latest economic indicators and survey results continue to suggest a moderate pace of growth in the euro area economy. The European Commission’s Economic Sentiment Indicator (ESI) increased in November to a level above its long-term average, although so far it has declined in quarterly average terms in the fourth quarter of the year. Overall, the composite output PMI was unchanged between October and November, remaining at levels suggesting continued moderate growth, despite its decline in quarterly average terms until November.

Looking ahead, favourable financing conditions will continue to support expansion within the euro area. The ECB’s accommodative monetary policy continues to support domestic demand. Ongoing employment gains, rising wages and improving households’ balance sheets should continue to support private consumption. At the same time, the ongoing – albeit somewhat slower – expansion in global activity is expected to underpin growth.

The December 2019 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 1.2% in 2019, 1.1% in 2020 and 1.4% in both 2021 and 2022 (see Chart 12). Compared with the September 2019 projections, real GDP growth has been revised down slightly by 0.1 percentage points in 2020, on account of downward revisions to foreign demand which are only partially offset by more supportive fiscal and monetary policies and an effective depreciation of the euro. The risks surrounding the outlook for euro area growth, related to geopolitical factors, rising protectionism and vulnerabilities in emerging markets, remain titled to the downside, but have become somewhat less pronounced.

Prices and costs

According to Eurostat’s flash estimate, euro area annual HICP inflation increased from 0.7% in October 2019 to 1.0% in November, reflecting mainly higher services and food price inflation. On the basis of current futures prices for oil, headline inflation is likely to rise somewhat in the coming months. Indicators of inflation expectations stand at low levels. Measures of underlying inflation have remained generally muted, although there are some indications of a mild increase in line with previous expectations. While labour cost pressures have strengthened amid tighter labour markets, the weaker growth momentum is delaying their pass-through to inflation. Over the medium term, inflation is expected to increase, supported by the ECB’s monetary policy measures, the ongoing economic expansion and solid wage growth. This assessment is also broadly reflected in the December 2019 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.2% in 2019, 1.1% in 2020, 1.4% in 2021 and 1.6% in 2022. Compared with the September 2019 ECB staff macroeconomic projections, the outlook for HICP inflation has been revised up slightly for 2020 and down slightly for 2021, mainly driven by the expected future path of energy prices. Annual HICP inflation excluding energy and food is expected to be 1.0% in 2019, 1.3% in 2020, 1.4% in 2021 and 1.6% in 2022.

According to Eurostat’s flash estimate, HICP inflation increased from 0.7% in October to 1.0% in November. This was mainly attributable to rises in services and food inflation and, to a lesser extent, an increase in non-energy industrial goods inflation, all of which more than offset a further small decline in energy inflation.

Measures of underlying inflation generally remained muted. HICP inflation excluding food and energy rose further to 1.3% in November, up from 1.1% in October and 1.0% in September, which also reflected the fading-out of downward effects associated with methodological changes.^[6] Alternative measures of underlying inflation that tend to be less volatile than HICP inflation excluding energy and food have been fairly stable over recent quarters (data available up to October only; see Chart 14). HICP inflation excluding energy, food, travel-related items and clothing stood at 1.1% in October, continuing its very gradual upward trend that had started at the beginning of 2017. Signals from other measures of underlying inflation, including the Persistent and Common Component of Inflation (PCCI) indicator and the Supercore indicator,^[7] point to a continuation of the broad sideways movement that has now been observed for several quarters.

Pipeline price pressures for HICP non-energy industrial goods remained broadly stable at the later stages of the supply chain. Producer price inflation for domestic sales of non-food consumer goods, which is an indicator of price pressures at the later stages of the supply chain, stood at 0.8% year on year in October, unchanged since July and above its historical average. The corresponding annual rate of import price inflation declined, standing at 0.5% in October, down from 0.9% in September. Indicators of price pressures at the earlier stages of the supply chain weakened somewhat, with annual producer price inflation for intermediate goods falling to ‑1.0% in October, down from ‑0.7% in September, and import price inflation for intermediate goods decreasing to ‑0.5% in October, down from 0.4% in September. Weaker external price pressures are signalled by developments in global producer price inflation excluding energy, which fell slightly further to 1.1% in October, down from 1.2% in September.

Wage growth has remained resilient. Annual growth in compensation per employee stood at 2.1% in the third quarter of 2019, down slightly from the 2.2% and 2.3% recorded in the second and first quarters respectively (see Chart 15). The figures for 2019 have been affected by a significant drop in social security contributions in France.^[8] Annual growth in wages and salaries per employee, which excludes social security contributions, was 2.5% in the third quarter, unchanged from the second quarter, after 2.6% in the first quarter and 2.3% on average for the previous year. Annual growth in negotiated wages in the euro area was 2.6% in the third quarter of 2019, up from 2.0% in the second quarter. This increase was due mainly to one-off payments in the manufacturing sector in Germany. Looking across the different indicators and through temporary factors, wage growth has moved broadly sideways since mid‑2018, either at around or slightly above historical averages.

Market-based indicators of longer-term inflation expectations have remained at very low levels, while survey-based expectations also stand at historical lows. Market-based indicators of inflation expectations remained broadly stable throughout the review period, hovering just above the new historical lows reached in early October 2019. The five-year forward inflation-linked swap rate five years ahead stood at 1.25% on 11 December 2019, around the same level as at the time of the September monetary policy meeting of the Governing Council. Nevertheless, the market-based probability of deflation remained contained, marking a turnaround in the upward trend observed in 2019. Overall, the forward profile of market-based indicators of inflation expectations continues to point to a prolonged period of low inflation. Survey-based long-term inflation expectations are also at historically low levels, according to the ECB Survey of Professional Forecasters for the fourth quarter of 2019, as well as the November releases from Consensus Economics and the Euro Zone Barometer.

The December 2019 Eurosystem staff macroeconomic projections foresee an increase in underlying inflation over the medium term. These projections, which are based on the information available at the end of November, expect headline HICP inflation to average 1.2% in 2019, 1.1% in 2020, 1.4% in 2021 and 1.6% in 2022, compared with 1.2%, 1.0% and 1.5% for the years 2019, 2020 and 2021 respectively in the September 2019 ECB staff macroeconomic projections (see Chart 17). The revisions were driven mainly by the expected future path of energy prices, which has been revised upwards for 2020 but downwards for 2021, owing to higher oil prices in the short term and a slightly more downward-sloping oil price futures curve. After a moderate rise by the end of 2019, HICP inflation excluding energy and food will move sideways at 1.3% in the course of 2020 and increase to 1.4% in 2021 and 1.6% in 2022. The upward path of HICP inflation excluding energy and food is expected to be supported by strengthening economic activity, by relatively robust wage growth amid tight labour markets and by recovering profit margins as activity regains pace, aided, among other things, by the ECB’s September 2019 monetary policy measures. Rising non-energy commodity prices are also expected to provide some support to HICP inflation excluding energy and food.

Money and credit

In October 2019 the annual growth of broad money remained robust, while lending to the private sector continued its gradual recovery. The resilient growth of M3 mainly reflected the very low opportunity cost of holding money. Favourable bank funding and lending conditions continued to support loan flows and thereby economic growth. Net issuance of debt securities by non-financial corporations (NFCs) increased in the third quarter of 2019, from an already robust outturn in the previous quarter. Bond market conditions continue to support debt securities issuance.

Broad money grew at a robust pace in October. The annual growth rate of M3 was unchanged at 5.6% in October (see Chart 18), slightly exceeding the rate of around 5% observed between 2015 and 2018, when net asset purchases under the asset purchase programme (APP) were positive. Broad money growth was supported by the very low opportunity cost of holding monetary instruments, while weaker economic growth acted as a drag on it. The interest rate constellation is also affecting the composition of M3, as it incentivises the concentration of volumes in the most liquid instruments. As in previous quarters, therefore, M3 growth continued to be driven by the narrow aggregate M1 – comprising overnight deposits and currency in circulation. The annual growth rate of M1 increased in October to 8.4%, from 7.8% in September, continuing the recovery observed since the start of the year.

Overnight deposits were the main contributor to money growth. The annual growth rate of overnight deposits increased further to 9.0% in October, from 8.5% in September. Stable developments in currency in circulation do not point to an accelerated substitution of deposits with cash in view of the negative interest rate environment. Short-term deposits other than overnight deposits (i.e. M2 minus M1) made a positive contribution to M3 growth in October, which was mainly attributable to stronger growth in saving deposits. At the same time, marketable instruments (i.e. M3 minus M2) continued to make a small negative contribution to broad money growth as a result of the relatively low remuneration of these instruments.

Credit to the private sector remained the main source of broad money creation in October. Credit to the private sector made a sizeable contribution to broad money growth (see the blue portion of the bars in Chart 19). The acceleration in broad money growth since early 2019, however, is mainly due to developments in external monetary flows (see the yellow portion of the bars in Chart 19). This development reflects greater interest on the part of foreign investors in euro area assets. At the same time, the end of net asset purchases under the APP at the end of 2018 implied that the contribution from general government securities held by the Eurosystem was marginal (see the red portion of the bars in Chart 19). Furthermore, the drag from longer-term financial liabilities remained small (see the dark green portion of the bars in Chart 19).

The annual growth rate of loans to the private sector picked up slightly, consolidating its gradual recovery. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) increased slightly to 3.7% in October, compared with 3.6% in September (see Chart 18). This development was mainly due to an increase in the annual growth rate of loans to NFCs, which rose to 3.8% in October, compared with 3.6% in September, therefore consolidating its stabilisation at levels around 4% since mid‑2018. Lending to firms in the services sector – including firms providing real estate-related services – accounts for the largest share of the growth in lending to NFCs. Annual growth in loans to households continued on its gradual upward trend, benefiting in particular from favourable lending conditions and housing market developments. The annual growth rate of loans to households increased slightly to 3.5% in October, compared with 3.4% in September. The growth in loans to firms and households continues to be characterised by considerable heterogeneity across countries (see Chart 20), reflecting, inter alia, cross-country differences in economic growth over time, variations in the availability of other funding sources, the level of indebtedness of households and non-financial corporations, and heterogeneity in house price developments across countries.

Banks’ debt funding conditions remained favourable. The composite cost of debt financing for euro area banks, which has decreased since the start of the year in line with market rates, remained at very low levels in the third quarter of 2019 (see Chart 21). This development reflects a considerable trend decline in bank bond yields, although there has been a slight rebound in bond yields since September, reflecting a broader increase in risk-free rates. At the same time, euro area banks’ deposit rates recorded new historical lows in October. While developments in banks’ debt funding costs were largely simultaneous in the largest euro area countries, reflecting the monetary policy measures of the ECB, the level of bank funding costs remained heterogeneous. In their responses to the ECB’s October 2019 euro area bank lending survey, euro area banks reported that the resumption of net asset purchases under the APP is expected to facilitate a further easing of market financing conditions, thereby contributing to further improvements in funding conditions. Moreover, the downward pressure on euro area banks’ loan-deposit margins, which exerts a dampening impact on bank profitability, is being compensated for by increasing lending volumes, and the overall effect on net interest income (as the product of lending margins and volumes) has been slightly positive. Despite the progress made by banks in consolidating their balance sheets, for instance by reducing non-performing loans, euro area bank profitability remains low by international and historical standards, and this can challenge banks’ capacity to intermediate and transmit monetary policy signals. Against this background, some of the non-standard monetary policy measures introduced recently by the ECB – such as TLTRO III and the two-tier system for reserve remuneration – are geared towards supporting bank-based intermediation.

Favourable lending rates continue to support economic growth. In the last few months composite bank lending rates for loans to NFCs have remained broadly unchanged, in line with developments in market reference rates, while the equivalent rates for loans to households for house purchase have continued to decline. In October 2019 the composite bank lending rate for NFCs (see Chart 22) stood at 1.56%, only marginally above its historical low, while the composite bank lending rate for housing loans fell to a new historical low when it declined to 1.44% (see Chart 22). Competitive pressures and more favourable bank funding costs have dampened lending rates for loans to euro area NFCs and households. Overall, composite bank lending rates for loans to NFCs and households have fallen significantly since the ECB’s credit easing measures were announced in June 2014. Between May 2014 and October 2019 composite lending rates on loans to NFCs and households for house purchase fell by around 140 and 150 basis points respectively.

The annual flow of total external financing to euro area NFCs remained solid in the third quarter of 2019. Overall, as financing conditions are currently favourable, debt financing flows to NFCs have remained quite resilient to the current economic weakness. In this respect, the Survey on the Access to Finance of Enterprises in the euro area (SAFE) shows that small and medium-sized enterprises, which depend critically on banks for financing, report a sustained willingness of banks to lend to them. External financing to firms edged up in the third quarter of 2019, benefiting from low and falling costs on financing instruments. In the third quarter of 2019 the net issuance of debt securities by NFCs increased, leaving issuance so far in 2019 close to record levels. The increase in the net issuance of debt securities in the third quarter of 2019 occurred in a context of gradual recovery in overall credit to NFCs – including MFI loans – and a further improvement in corporate bond financing conditions that was more pronounced than the improvement in bank lending conditions. From a medium-term perspective, the recovery in debt securities issuance in 2019 has brought annual net issuance flows in September back to the levels recorded in spring 2018 and well above the trough of December 2018 (see Chart 23). Net issuance of listed shares was positive in September but remained negative for the whole third quarter of 2019, reflecting both sluggish merger and acquisition activity and an increase in the cost of equity financing over the period. Recent market data suggest that the net issuance of debt securities in October and November 2019 remained strong and was still dominated by investment-grade issuers, although high-yield issuance activity also increased.

In September 2019 the cost of financing for NFCs stood close to its historical minimum recorded in April 2019. In September the overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, stood at 4.6%. This was 9 basis points higher than in April, when the cost of financing series was at its historical low but still very favourable. By the end of November, the overall cost of financing is estimated to have remained broadly unchanged from September. This reflects a slightly lower cost of equity, which was compensated for by a marginally higher cost of market-based debt. The lower estimated cost of equity was mostly driven by a decline in equity risk premia, in turn supported by an improvement in global risk sentiment. Meanwhile, the slight increase in the cost of market-based debt was due to an increase in risk-free rates, while corporate bond spreads declined over the same period.

Fiscal developments

The euro area fiscal deficit is expected to increase steadily during the years 2019‑21 on account of lower primary surpluses. The decline in the primary balance reflects mainly a projected expansionary fiscal stance, which provides support to economic activity. The euro area government debt-to-GDP ratio is expected to remain on a downward path owing to a favourable interest rate-growth differential and a positive – even if declining – primary balance. However, debt levels in a number of countries remain high. In these countries, governments need to pursue prudent policies and meet structural balance targets, which will help create the conditions that will allow automatic stabilisers to operate freely. In view of the weakened economic outlook, governments with fiscal space should be ready to act in an effective and timely manner.

The euro area general government budget balance is projected to decline steadily during 2019‑21 and to stabilise in 2022. ^[9] Based on the December 2019 Eurosystem staff macroeconomic projections, the general government deficit ratio for the euro area is expected to have increased from 0.5% of GDP in 2018 to 0.7% of GDP in 2019. The deficit is projected to continue increasing in 2020 and 2021, and to stabilise thereafter at 1.1% of GDP (see Chart 24). The decline in the budget balance in 2019‑21 stems mainly from a lower cyclically adjusted primary balance. This is partly compensated by lower interest expenditure, while the cyclical component remains largely unchanged over the projection horizon.

The euro area fiscal outlook for 2020‑21 implies a somewhat more supportive fiscal policy than in the September 2019 ECB staff projections. After a slight upward revision in 2019, the lower budget balance in 2020 and 2021 reflects additional fiscal loosening, while the cyclical component and the interest payment projections remain broadly unchanged.

The aggregate fiscal stance for the euro area is assessed to be expansionary in 2019‑21 and broadly neutral in 2022. ^[10] The fiscal stance is estimated to loosen in 2019 and projected to remain expansionary in the years 2020‑21, providing support to economic activity. This is mostly on account of cuts in direct taxes in France and the Netherlands, higher transfers and public investment in Italy and Germany, and higher government consumption in Germany, the Netherlands and Spain. In 2022 the fiscal stance is projected to be broadly neutral, with some limited further direct tax cuts in France and additional expenditure in Germany and Spain.

The euro area aggregate public debt-to-GDP ratio is projected to remain on a downward path. According to the December 2019 Eurosystem staff macroeconomic projections, the aggregate general government debt-to-GDP ratio in the euro area is expected to decline from 85.8% of GDP in 2018^[11] to 81.1% of GDP in 2022. This reduction is supported by a favourable interest rate-growth differential^[12] and primary surpluses that are, however, diminishing (see Chart 25). Compared with the September projections, the debt ratio is projected to be on a slightly higher path owing to upward revisions to historical data (0.5% of GDP in 2018), lower projected primary surpluses and less favourable interest rate-growth differentials in 2020‑21.

Even though the debt ratio is expected to fall in most euro area countries, it will continue to significantly exceed the reference value of 60% of GDP in some of them. In those countries where government debt remains high, governments need to pursue prudent policies and meet structural balance targets, which will create the conditions for automatic stabilisers to operate freely. Governments with fiscal space should be ready to act in an effective and timely manner in view of the weakening economic outlook and the continued prominence of downside risks. At the same time, all countries should intensify their efforts to achieve a more growth-friendly composition of public finances.

Boxes

The effects of tariff hikes in a world of global value chains

Prepared by Philipp Meinen

In the context of the trade conflict between the United States and China, global value chains (GVCs) are a potential factor amplifying the impact of higher tariffs on economic activity. Raising tariffs in a globalised world with international supply chains can have significant negative repercussions on economic activity. In general, global sourcing by firms implies that higher tariffs, usually imposed to protect a domestic industry, can lead to higher input costs for domestic producers. In addition, the effects of higher tariffs may be magnified by GVCs, especially in the case of multistage production processes, where goods move in a sequential manner from upstream to downstream with value added at each stage.^[13] Against this background, this box provides some evidence of the adverse effects of tariffs on economic activity in the context of global sourcing and GVCs.

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Market reaction to the two-tier system

Prepared by Luca Baldo, Cristina Coutinho and Nick Ligthart

On 30 October 2019 the ECB implemented a two-tier system under which a portion of credit institutions’ excess liquidity holdings with the Eurosystem are exempt from remuneration at negative rates. The two-tier system applies to excess liquidity held by banks in current accounts with the Eurosystem and not to holdings with the ECB’s deposit facility.^[14] Excess liquidity holdings (i.e. reserve holdings in excess of minimum reserve requirements) that are exempt are remunerated at 0%, instead of at the rate of the deposit facility, currently ‑0.5%.

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Liquidity conditions and monetary policy operations in the period from 31 July to 29 October 2019

Prepared by Luca Baldo and Denis Lungu

This box describes the ECB’s monetary policy operations during the fifth and sixth reserve maintenance periods of 2019, which ran from 31 July to 17 September 2019 and from 18 September to 29 October 2019, respectively. The review period encompasses the substantial package of monetary policy measures adopted by the Governing Council on 12 September 2019. The package consists of five elements: (i) a reduction in the interest rate on the deposit facility from ‑0.40% to ‑0.50%, effective from 18 September, while keeping the interest rates on the main refinancing operations (MROs) and the marginal lending facility unchanged at 0.00% and 0.25%, respectively; (ii) adjustments to the forward guidance on the key ECB interest rates; (iii) the restart of net purchases under the asset purchase programme (APP) from 1 November; (iv) modifications to the modalities of the new series of targeted longer-term refinancing operations (TLTRO III); and (v) the introduction of a two-tier system for reserve remuneration, effective as of the seventh reserve maintenance period starting on 30 October 2019. In parallel, the Eurosystem continued to reinvest, in full, the principal payments from maturing securities purchased under the APP. Furthermore, on 2 October 2019, the ECB started publishing the new overnight unsecured benchmark rate for the euro area, the euro short-term rate (€STR). From that date, the calculation methodology for the euro overnight index average (EONIA) was also changed to calculate EONIA by applying a fixed spread of 8.5 basis points to the €STR.

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Indicators of labour market conditions in the euro area

Prepared by Vasco Botelho and António Dias da Silva

This box presents two complementary tools for assessing the performance of the labour market in the euro area. The first is a visualisation tool in the form of a spider chart that displays 18 variables characterising the current euro area labour market conditions. The second applies a principal component analysis to the variables displayed on the spider chart. This approach summarises the available information on euro area labour market conditions in two synthetic indicators^[15]: level of activity and labour market momentum. The indicator for the level of activity compares developments in the labour market over time, while the indicator for the labour market momentum assesses the rate of change in the performance of the labour market. The analysis presented is for the euro area as a whole and does not fully show cross-country labour market heterogeneity.

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Recent developments in social security contributions and minimum wages in the euro area

Prepared by Ferdinand Dreher, Omiros Kouvavas and Gerrit Koester

The behaviour of labour costs can be significantly affected by country-specific changes in social security contributions and minimum wages. An awareness of the nature and magnitude of such factors is important when assessing the strength of wage growth and its implications for producer and consumer price inflation. This box examines how these two factors have affected aggregate euro area wage growth.

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Export activities of euro area SMEs: insights from the Survey on the Access to Finance of Enterprises (SAFE)

Prepared by Katarzyna Bańkowska, Annalisa Ferrando and Juan Angel Garcia

This box reports the responses to an ad hoc question in the latest round of the Survey on Access to Finance of Enterprises (SAFE) regarding the export activities of small and medium-sized enterprises (SMEs).^[16] It has two aims: first, it provides an overview of the export activities of euro area SMEs, both within and outside the euro area; and, second, it explores the main characteristics of exporting SMEs and focuses on the analysis of some financial dimensions that are relevant to the decision to export, as derived from the survey responses.

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The review of draft budgetary plans for 2020 – some implications for a reform of fiscal governance

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

On 21 November 2019 the European Commission released its opinions on the draft budgetary plans of euro area governments for 2020, together with an analysis of the budgetary situation in the euro area as a whole. Each opinion includes an assessment of the compliance of the relevant plan with the Stability and Growth Pact (SGP) based on the Commission’s 2019 autumn economic forecast. This review exercise also assesses whether countries have incorporated into their plans the country-specific recommendations for fiscal policies that were addressed to them under the 2019 European Semester, as adopted by the Economic and Financial Affairs Council on 9 July 2019.^[17] The recommendations call on countries with high ratios of government debt to GDP to aim for a sufficiently fast reduction of these ratios. Some countries with room for budgetary manoeuvre are recommended to make use of this room, including for achieving an upward trend in government investment. The review of the draft budgetary plans identifies weaknesses in the follow-up to the recommendations. It is important that such shortcomings be addressed, inter alia, in the Commission’s forthcoming review of the “six-pack” and “two-pack” regulations, which were implemented in 2011 and 2013 respectively in the aim of strengthening fiscal governance.

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Articles

What does the bank lending survey tell us about credit conditions for euro area firms?

Prepared by Lorenzo Burlon, Maria Dimou, Anna-Camilla Drahonsky and Petra Köhler-Ulbrich^[18]

This article examines bank lending conditions for euro area non-financial corporations (NFCs), making use of the wealth of soft information available in the euro area bank lending survey (BLS) since its inception in 2003. One relevant question in this context is whether the tightening of the bank loan supply during the financial and sovereign debt crises has been offset by the easing of bank lending conditions for loans to NFCs since 2014. The article illustrates that the easing over this period has come mainly through a substantial loosening of the actual terms and conditions applied by banks to new loans to firms of average credit quality, while the credit standards that banks have established for their loan approval decisions have eased by less. The article also draws on the responses of individual banks to examine the differences in bank lending conditions for NFC loans over time and across bank business models. This analysis reveals that the change in credit conditions of banks with business models more reliant on stable funding sources, such as deposits, is more muted. In short, it looks at additional aspects that enhance the regular assessment of bank lending conditions faced by firms based on the euro area BLS.

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The effects of changes in the composition of employment on euro area wage growth

Prepared by Omiros Kouvavas, Friderike Kuik, Gerrit Koester and Christiane Nickel

Until recently, wage growth in the euro area has been low and under-predicted. Looking at the period 2013‑17, this weakness can be explained to a large extent by the factors traditionally captured in a Phillips curve analysis, such as economic slack and inflation expectations. Slack in the labour market can be measured by a broad range of different indicators, which include “narrow” indicators (e.g. the unemployment rate) or more unconventional measures such as the broad unemployment rate. The latter also includes euro area working age population marginally attached to the labour force – i.e. those members of the labour force categorised as inactive but still competing, albeit less actively, in the labour market.^[19] In general it seems that broader measures of labour underutilisation brought some marginal gains in explaining the subdued wage growth observed in the euro area over the period 2013‑17.^[20] However, the factors traditionally included in a Phillips curve analysis do not paint the full picture.^[21]

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The performance of the Eurosystem/ECB staff macroeconomic projections since the financial crisis

Prepared by Kyriacos Lambrias and Adrian Page

This article evaluates the performance of the Eurosystem/ECB staff macroeconomic projections for the euro area in the context of the elevated macroeconomic volatility and uncertainty that has prevailed since the financial crisis. It finds that there has been considerable variability in projection errors over time. With regard to real GDP growth projections, errors that were substantial during the sovereign debt crisis have become more limited in recent years. As for headline inflation, unexpected fluctuations in oil prices – which in the staff macroeconomic projections are assumed to follow the path of oil price futures – played a dominant role in explaining the errors, as was the case during the pre-crisis years. On the other hand, HICP inflation excluding energy and food has been persistently overprojected since 2013. While these projection errors can also partly be attributed to errors in the conditioning technical assumptions, other factors (such as modelling errors, changes in economic relationships or judgement) have also played a key role at different points in time. The forecast performance of the Eurosystem/ECB staff macroeconomic projections has been broadly similar to that of other international institutions and of private sector forecasters, suggesting that projection errors have been mainly driven by common elements. These may include economic shocks unforeseeable to any forecaster and developments that have become more prominent since the financial crisis, including, among other things, structural reforms, changes in the relationship between slack and prices, globalisation and digitalisation. The article is structured as follows: Section 1 explains how the staff macroeconomic projections are constructed/compiled, Section 2 provides an overview of the errors made in projecting real GDP and HICP inflation since 2010,^[22] Section 3 reviews some of the sources of the errors, and Section 4 provides a comparison with the forecasting performance of other institutions and private sector forecasters.

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Statistics

Statistical annex