An insight into the European Central Bank's latest decision
On 25th October 2018, the Governing Council of the European Central Bank (ECB) came together to decide how to further pursue their monetary policy goal of keeping the inflation rate hovering just below 2% for the eurozone area. Due the importance of this decision, the ECB is closely watched and scrutinized by many public and private sector actors. This info-piece will take a critical look at the driving factors that motivated the ECB in their decision-making process and how they justify the outcome of this meeting.
The principal outcomes of the ECB’s October meeting are: keeping the main interest rate at 0.00% for main refinancing operations, at 0.25% for the marginal lending facility rate and at -0.40% for the deposit facility rate until mid-2019 at least, ending the asset purchase program (APP) after December 2018, and reinvesting the inflow of payments of maturing securities bought through it from January 2019 onwards.
To understand these decisions, it is important to comprehend the relationship between economic growth performance in the euro area, and the factors and risks that can slow it down, such as domestic demand and, wage growth, and inflation. To do so this article considers the speech Mario Draghi gave at the European Banking Congress this November and explains how these factors play into the monetary policy definition of the ECB.
Economic growth performance in the euro area has slowed down this year after a steady increase over the last five years. Nevertheless, the ECB estimates this to be temporary and expects the economic expansion to soon pick up again. Historically, they might be right, since the current period of expansion has been both “short in length and small in size” in comparison to European GDP expansion periods since 1975 and to the recent American expansion.
One reason for the slowdown, as pointed out by Mr. Draghi, is the so-called “one-off” factors like “weather, sickness and industrial action” negatively impacting the output levels in several states, as well as, for example, the new emissions standards for vehicles, that entered into effect this September. The car production sector reacted accordingly and took off 0.1% of the growth rate for Q3, affecting countries like Germany the most. However, the ECB states that the automobile sector is already normalizing and is expected to return to normal output levels by the end of this year. Thus, the negative effects of these “one-off” factors should be largely temporary.
The second cause for the recent slump stems from the deceleration of world trade growth this year, driven by the fading of previously supportive factors such as trade liberalization and the implementation of international value chains, as well as the normalization of global trade growth to its potential, given the fact that 2017 was a particular strong year in this regard.
There are two risks that could imperil a further stabilization of world trade. Firstly, there is protectionism and trade uncertainties that can decrease the export performance of the eurozone and that have already damaged export-oriented economies. Secondly, there is the risk of a “spill-over” effect that threatens to affect domestic production due to external demand. So far, the ECB doesn’t see data proving that domestic business investment has been affected by this year’s growth development. Still, companies in sectors that are expected to be most hit by the mechanisms of protectionism (i.e. tariffs) have decreased their capital expenditures in new investments or projects.
Mario Draghi, while recognizing the dangers, states that “overall risks to the growth outlook” remain well-balanced due to the relative strength of domestic demand, which depends heavily on the composition of employment, labor income and consumption, and the interaction between them. These three factors are described as the biggest source of recovery and expansion throughout the last years and data indicates that they have not taken a hit by the sluggish growth performance of 2018. This is due to three factors:
Firstly, employment growth has been built on longer-term structural changes, which are typically not too affected by cyclical swings, and has been fueled by a rise in labor demand in those countries that have implemented the reforms effectively (i.e., Germany, Portugal, Spain). Secondly, because of the positive effect that consumption has on job growth, as most consumers spend their money on the services-sector, which usually has a “higher labor-intensity” than many export-oriented industries (i.e. “higher manufacturing content”. Lastly, thanks to the supportive economic impact of the ECB’s accommodative monetary policy and its “very favorable financing conditions”, both of which have led to high levels of growth in loans to firms and to households - the latter being supported by the increase of house prices and further fueling consumption growth.
Of course, some risk factors remain that could change financing conditions. One is the non-compliance of high-debt countries regarding their fiscal consolidation, making them more vulnerable to economic shocks of any kind that would lead to higher interest rates for their firms and households. Additionally, there is a “possibility of a disorderly increase in global risk premia” that shall be further monitored, as international factors can strongly impact the ECB’s future decisions.
Finally, we must consider the impact of wage growth and inflation. In Q2 of 2018 the annual growth in wages per employee has hit 2.3%, a positive development compared with recent years and something that has been supported by the domestic expansion in the euro area economies. Mr. Draghi argues that the overall tightness of the European labor market and labor shortages (which have become more frequent in the euro area) are two factors supporting further compensation growth. Also, so-called “negotiated wages” have been rising over the last two years, suggesting that wage growth is expected to climb increasingly.
As for inflation, there hasn’t been a strong pass-through of said wage growth to the Consumer Price Index (CPI), with core inflation revolving around the 1% mark. Historical evidence suggests that this is a normal behavioral pattern during the current eurozone’s situation, as Mr. Draghi claimed that “the pass-through is systematically faster and stronger in periods of higher inflation than in periods of lower inflation”. Thus, the degree of pass-through is expected to increase and lead to higher prices in the euro area at some point in the near- to medium-future. Nevertheless, this is a variable affected by the overall outlook and certainty, or uncertainty, of growth and inflation.
This gives a good overview of the underlying driving factors that the ECB evaluated when they made up their minds regarding adjustments of their monetary policy for the end of 2018 and beginning of 2019. Domestic demand and wages aided the pursuit of the 2% inflation goal. The dynamic that plays out between wages and prices and the reasons for a delay in the pass-through also explain why the ECB chose to stay on course; as patience is required to reach the desired outcome.
By maintaining their key interest rates on low levels, shifting out of their APP by the end of the year and instead reinvesting maturing bonds for “as long as necessary to maintain favorable liquidity conditions and (…) monetary accommodation,” the ECB seems to be convinced that they will achieve the desired inflation convergence. Nevertheless, they need to stay vigilant for unexpected negative developments in order to make swift decisions to adapt to the situation accordingly and in due time - something the ECB has been accused of not doing in the past by some critics.
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