The wider economy

The data has been compiled from publicly available information released by the European Central Bank, European Commission, Eurostat, the European Banking Authority, International Monetary Fund, national competent authorities and members of the European Banking Federation. Unless otherwise noted, all graphs and tables have been produced to illustrate the figures mentioned in the relevant chapters.

After years of moderate but steady economic growth the euro area economy will continue its recovery. The uninterrupted recovery which started in the second quarter of 2013 helped the euro area bloc to grow at 1.6% and at a faster pace in 2016 than the economic expansion in the United States, for first time since the financial crisis. This was also a higher rate than international partners such as Canada (1.4%) and Japan (1.0%) and parallel to the UK (1.8%). The euro area however has a lower expected growth rate for 2017 and 2018 than the EU 28 and the US. The slowdown is driven primarily by political uncertainty in Europe and the US and geopolitical tensions which are presently surrounding the world economy. A realisation of slowing Chinese growth could further hamper growth.

Having increased from 2015 to 2016, private and public consumption growth rates are expected to decrease in 2017 to 1.4% (1.9% in 2016) and 1.2% (2.0% in 2016), respectively. Private consumption nonetheless remains the main driver of growth in the euro area. Aggregate demand will continue to be stimulated by monetary policy. With the global economy continuing to recover, exports are expected to increase by 3.7% compared with 2.7% in 2016, with imports experiencing a marginal increase as well.

Further positive changes in the euro area are expected to materialise in 2017 and 2018. Unemployment is expected to decrease in 2017 from 10.0% to 9.5%, falling to 9.1% in 2018. This remains significantly higher than the US (4.7%) and Germany (3.9%), but represents a positive trend. Wage growth is expected to be 1.6% in 2017, doubling from 2016’s 0.8%, with a further marginal increase expected in 2018.

Rising inflation rates propelled mostly by the increase in the price of Brent oil are expected to bring inflation to 1.6% in 2017, the closest rate to the ECB’s target in over four years, alleviating any remaining concerns about deflation. Core inflation, however, is expected to be only 1.1% in 2017.

These conditions are complemented by a renewed potential for labour and financial market reforms in Europe. The election of President Macron in France is expected to inject new energy into French and German cooperation, especially after Germany’s federal election in September, which could help induce such reforms. Further, the effects of President Junker’s Investment Plan for Europe may also begin to materialise in 2017 and 2018, assisting growth.

With key variables moving in a positive direction, including a better global outlook, the euro area is expected to experience continued growth in 2017 and beyond. However, such conditions are underlined by relatively high and unequal rates of unemployment, especially among youth and minorities. Employment in industry and construction sectors also remain far below their pre-crisis levels. Moreover, while political uncertainty in Europe has declined after the French and Dutch general elections, future elections in Italy, along with continued geopolitical risk in Ukraine, Russia, Turkey, and the Middle East, threaten to bring about new shocks to the European economy. Uncertainty from the United States, not least its positions on trade and international monetary policy, and the level of complexity of the Brexit negotiations and the relative short time in which to reach a final deal could also lead to changes in these expectations.

The Chief Economists’ Group of the European Banking Federation in its Spring 2017 Outlook of the Euro Area Economies in 2017 – 2018 reflects that the current economic outlook remains surrounded by a number of both upside and downside risks with the risks to the growth outlook fairly balanced.

Monetary Policy and Inflation: Why it matters and how it works

Why monetary policy is important

Monetary policy is one of the main responsibilities of a central bank.

The primary aim of monetary policy is usually price stability. In practice, most central banks have set a target for inflation up to, but close to, 2%.

Central banks believe that price stability contributes to achieving high levels of economic activity and employment. This is because high or unstable inflation rates reduce business confidence or certainty and make spending or investment decisions unnecessarily complex, contributing to wasteful activities aimed at preserving wealth or hedging against inflation risk.

Central banks usually have secondary monetary policy aims related to employment and economic growth.

Monetary policy has traditionally centred on the role of the central bank as the sole issuer of banknotes and bank reserves in an economy. This means it can set the conditions at which banks borrow from the central bank i.e. the official interest rates. In this way it can also influence the conditions at which banks trade with each other in the money market and the rates set in lending to and deposit-taking from non-banks.

Through its official interest rates, and the expectations for rates and prices, that its monetary policy has created, a central bank can influence asset prices, saving and investment decisions, credit supply and exchange rates. These in turn affect supply and demand for labour and goods and services while setting expectations for wages and prices.

Since 2009, a number of central banks have expanded their monetary policy instruments to include asset purchase programmes or quantitative easing. These assets may include government or public sector bonds, corporate bonds, asset-backed securities and covered bonds.

Central banks do this mainly to create money, increasing the banks’ reserves and incentivising them to lend more.

How monetary policy works

Interest rates are a central bank’s primary tool to impact economic conditions within a country. Through its use of open market operations, a central bank can effectively set a country’s interest rate, having a direct and indirect impact on a country’s economy.

In the short term, a change in the interest rate directly impacts the domestic return of a given country. Changes in these rates therefore influence the exchange rate of a currency, leading a currency to appreciate if the interest rate in that economy increases, or vice-versa if the interest rate decreases. These changes then alter the country’s purchasing power of foreign goods, which will in turn affect the prices of these goods.

Alterations in the interest rate also affect the interest rates which banks charge consumers, such as mortgage rates or credit card rates. Further, interest rates also have an impact the value of money and the price level of assets. These changes in turn will influence the supply and demand of goods and labour within an economy. Changes in the equilibrium of either of these markets will directly shift the price level within an economy, affecting both wages and domestic prices.

Along with these short-term impacts, changes in a country’s interest rate impact investor expectations as the profitability of future endeavours will change depending on the expected direction of the interest rate. For instance, lower expected inflation rates make it cheaper to borrow funds for a project in the future, leading investors to delay investing until these lower rates are realised. This in turn implies that profits will be expected to rise in the future, leading labour and capital to delay wage increases.

There are, however, certain types of shocks over which a central bank has no control. The most significant of these shocks include important changes to the global economy or changes in fiscal policy within a country. These changes can further be compounded by increased uncertainty within that country, which impacts investor expectations. Other external changes include changes in risk premia, changes in commodity prices, such as through new developments in technology, and changes in bank capital, which may be the result of new bank regulations.

Influencing inflation

With its aim of achieving price stability within the euro area, the ECB strives to ensure that inflation does not exceed the ECB’s target of near, but close to, 2% inflation over the medium term.

As high levels of inflation dilute a person’s real income and their purchasing power, ensuring price stability is a vital aspect of a prosperous economy. As a result, the ECB will react to changes in the European economy by wanting to stimulate or lessen inflation.

Historically, the ECB would use conventional monetary policy to influence inflation by setting interest rates. For instance, to increase inflation the ECB would cut interest rates, stimulating the economy. This is usually done by buying government bonds, which increases an economy’s money supply. However, as has been witnessed since 2008, these tools may not always be effective. Another way to influence inflation is through quantitative easing, where a central bank purchases commercial assets.

The effects of these policies may not always materialise immediately. Consumers take time to adjust to new interest rates, creating a lag between monetary policy and inflation.

Further, inflation can either be measured as “Headline Inflation” or “Core Inflation”. The former includes all goods within an economy, while the latter excludes goods with volatile prices, such as oil. Core inflation can therefore provide a more accurate measure of a country’s long-term price level.

The ECB focuses on achieving its target by measuring headline inflation. While the ECB’s target is arbitrary, setting a clear inflation target allows investors to adjust their expectations.

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