The Governing Council of the European Central Bank, held in Frankfurt am Main on the 25-26 July 2018, reviewed the latest financial, economic and monetary developments since the Governing Council’s previous monetary policy meeting on 13-14 June 2018.
Financial market developments
The slope of the US Treasury and German government bond yield curves, measured as the difference between the ten-year and two-year yields, had continued their flattening trend of recent months. In particular, between April and July 2018 estimates of the term premium in the United States had fallen deeper into negative territory despite factors which should have led, in principle, to a decompression of the premium, such as the gradual balance sheet wind-down by the Federal Reserve System and expectations of an increase in the supply of US Treasury securities based on a projected rise in the US fiscal deficit.
The most recent decline in term premia, both in the United States and in the euro area, might partly be attributed to the growing uncertainty over the global economic outlook owing, among other factors, to escalating trade disputes. This may have affected confidence among investors and contributed to an increase in demand for US Treasuries and German government bonds, widening the negative term premia that also reflected the stock effect of large-scale asset purchases.
Moreover, following the June Governing Council meeting, market participants’ expectations of a first rate increase by the ECB had been pushed further into the future, as suggested by market pricing and the latest analyst surveys. This partly reflected the Governing Council’s enhanced forward guidance on the future path of policy rates, which had also contributed to reducing interest rate uncertainty.
In foreign exchange markets, the euro had traded in a very narrow range against the US dollar. However, in nominal effective terms, the euro had appreciated, in particular against the currencies of a number of developing and emerging market economies. Part of the depreciation of these economies’ currencies was likely related to the growing uncertainty over the impact of trade tensions.
Trade tensions were also seen by market participants to have had a negative impact on stock market valuations, most notably in China. Since its peak in late January 2018, the China Securities Index 300 had declined by nearly 20%, while other stock market indices in the region had also fallen but to a lesser extent. These equity market sell-offs no longer affected only sectors that would be most hit by tariffs. Rather, they had become more broad-based, possibly reflecting increasing concerns among investors over the impact of protectionist measures on the global growth outlook.
Credit spreads in emerging market economies had increased measurably, by around 80 basis points, since the start of 2018. However, they remained well below the levels observed in 2015 and early 2016.
The global environment and economic and monetary developments in the euro area
Regarding the external environment, the global economic expansion had continued, while trade had weakened further. At the same time, inflation dynamics had gained some momentum. Annual consumer price inflation in the OECD area had edged up to 2.6% in May, with inflation excluding food and energy also increasing marginally. Brent crude oil prices had decreased by 2.2% (in US dollar terms) since the June monetary policy meeting. Over the same period, non-oil commodity prices had decreased by 7.4%, food prices by 6.7% and metal prices by 9.7% (all in US dollar terms).
Looking at the euro area, the incoming data confirmed that the moderation in the first quarter of 2018 had reflected a pull-back from the very high growth levels of previous quarters, mostly on account of weaker export demand with some contribution from temporary and supply-side factors. The breakdown of first-quarter growth into its components showed that domestic demand and changes in inventories had contributed positively to the outturn, whereas the contribution of net exports had been negative.
High frequency indicators released since the June meeting had confirmed the ongoing broad-based expansion. The flash composite output Purchasing Managers’ Index for July had decreased only slightly to 54.3, from 54.9 in June. Moreover, consumer confidence and confidence in the construction sector had remained at elevated levels, well above their historical averages. Favourable financing conditions, a robust labour market, and steady income and profit growth had continued to support private consumption and investment.
The June 2018 Eurosystem staff projections for euro area real GDP growth were broadly aligned with, or slightly below, available forecasts from other international institutions.
Turning to price developments, according to Eurostat’s flash estimate, euro area annual HICP inflation had stood at 2.0% in June, up from 1.9% in May. The increase reflected higher inflation rates for the energy and food components, which had more than offset a decline in HICP inflation excluding energy and food. Meanwhile, measures of underlying inflation remained muted overall but had been increasing from earlier lows.
Annual growth in compensation per employee had increased to 2.0% in the first quarter of 2018, up from 1.8% in the fourth quarter of 2017. In the first quarter of 2018, the impetus for this upward trend had come from stronger negotiated wage growth, rather than wage drift, as had previously been the case. This shift to negotiated wage growth as the main driver bolstered confidence that the pick-up in wage growth would be sustained.
Both market and survey-based inflation expectations were largely unchanged since the June meeting. Compared with other forecasts, the June Eurosystem staff projections for euro area HICP inflation were at the upper end of the range for 2018 and in the middle of the range for 2019 and 2020.
Financial conditions had remained broadly stable, in spite of some exchange rate appreciation in nominal effective terms and lower equity markets. The Governing Council’s June decisions had reduced interest rate uncertainty. In the weeks following the June meeting, EONIA forward rates had continued to decline, accompanied by a further flattening of the forward curve. Meanwhile, mounting global trade tensions weighed on euro area equity markets, while there were only modest changes in sovereign and corporate debt markets. The overall cost of financing for euro area firms had remained very favourable.
Turning to money and credit developments, the annual growth rate of the broad monetary aggregate M3 had risen to 4.4% in June from 4.0% in May. From a counterpart perspective, domestic sources of money creation had remained the main driver of M3 growth. The annual growth rate of loans to the private sector had continued its recovery, increasing to 3.5% in June, up from 3.3% in May. This acceleration had been mainly driven by loans to non-financial corporations (NFCs), which had stood at 4.1% in June.
At the euro area level, the composite cost of borrowing for NFCs had fallen to a new historical low in May, while the borrowing costs of loans for house purchase had remained stable at 1.8%. Moreover, according to the July 2018 euro area bank lending survey, credit standards had continued to ease for NFCs and households in the second quarter of 2018. The main factors contributing to the net easing had been competition and risk perceptions reflecting solid economic growth in the euro area.
Finally, with regard to fiscal policy, the euro area fiscal stance, measured as the change in the cyclically adjusted primary balance, was projected to stay mildly expansionary in 2018.
Monetary policy considerations and policy options
The most recent economic indicators and survey results had stabilised and confirmed the scenario of solid and broad-based growth momentum in line with the June Eurosystem staff projections.
Risks to the growth outlook could still be assessed as broadly balanced. Uncertainties related to global factors remained prominent. In addition, the risk of persistent heightened financial market volatility continued to warrant monitoring.
The strength of the euro area economy supported confidence that the convergence of inflation to levels below, but close to, 2% over the medium term would continue in the period ahead. This confidence was further bolstered by rising wages and increasing price pressures at the early stages of the pricing chain.
At the same time, underlying price pressures were building up only gradually, which argued in favour of patience, prudence and persistence with regard to the conduct of monetary policy in the period ahead.
On the basis of this assessment, Mr Praet proposed keeping monetary policy unchanged and reconfirming all elements of the Governing Council’s forward guidance.
It was important for communication to emphasise that the incoming data confirmed that the euro area economy was proceeding along a solid and broad-based growth path and underlined that risks surrounding the euro area growth outlook could still be assessed as broadly balanced, but uncertainties related to global factors remained prominent.
It was furthermore important to highlight that the underlying strength of the euro area economy continued to provide confidence that the convergence of inflation to levels below, but close to, 2% over the medium term would proceed in the period ahead, as well as to stress that a significant monetary policy stimulus remained necessary for the sustained convergence of inflation.
Likewise important was for the Governing Council to reiterate that an ample degree of monetary accommodation would continue to be provided by the net asset purchases until the end of 2018, by the sizeable stock of acquired assets and the associated reinvestments, and by the enhanced forward guidance.