Economic and monetary developments

Overview

At its monetary policy meeting on 2 June 2016, the Governing Council assessed that the comprehensive package of decisions taken in early March underpins the momentum of the euro area’s economic recovery and fosters the return of inflation to levels below, but close to, 2%. The ECB’s measures continue to ease the cost of credit and contribute to a strengthening in credit creation. The economic recovery in the euro area is proceeding gradually. Additional monetary stimulus, beyond the impetus already taken into account, is expected from the monetary policy measures still to be implemented, namely the corporate sector purchase programme (CSPP) and the new series of targeted longer-term refinancing operations (TLTRO II), and will contribute to further rebalancing the risks to the outlook for growth and inflation. In the current context, it is crucial to ensure that the very low inflation environment does not become entrenched in second-round effects on wage and price setting. The Governing Council will closely monitor the evolution of the outlook for price stability and, if warranted to achieve its objective, will act by using all the instruments available within its mandate.

Economic and monetary assessment at the time of the Governing Council meeting of 2 June 2016

Global growth remained subdued in the first quarter of 2016. Looking ahead, global activity is expected to continue to expand at a modest pace. Low interest rates, improving labour markets and growing confidence support the outlook for advanced economies. By contrast, the outlook for emerging market economies remains more uncertain as growth in China decelerates and commodity-exporting countries adjust to lower commodity prices.

Between early March and early June euro area and global financial markets returned to more stable conditions. A better than expected global economic performance, a further recovery in oil prices and additional monetary stimulus in the euro area supported the valuations of risky assets. Consequently, euro area equity prices increased moderately over the review period, while the announcement of the Eurosystem’s corporate sector asset purchases significantly reinforced the decline in spreads on bonds issued by non-financial corporations. Long-term euro area sovereign yields declined somewhat, closely mirroring movements in global long-term yields. In foreign exchange markets, the euro strengthened mildly.

The economic recovery in the euro area is continuing. Euro area real GDP increased significantly in the first quarter of 2016. Growth continues to be supported by domestic demand, while being dampened by weak exports. The latest data point to ongoing growth in the second quarter, though possibly at a lower rate than in the first quarter.

Looking ahead, the Governing Council expects the economic recovery to proceed at a moderate but steady pace. Domestic demand remains supported by the pass-through of the monetary policy measures to the real economy. Favourable financing conditions and improvements in corporate profitability continue to promote investment. Moreover, sustained employment gains, which are also benefiting from past structural reforms, and still relatively low oil prices provide additional support for households’ real disposable income and private consumption. In addition, the fiscal stance in the euro area is slightly expansionary. However, the economic recovery in the euro area continues to be dampened by subdued growth prospects in emerging markets, the necessary balance sheet adjustments in a number of sectors and a sluggish pace of implementation of structural reforms.

The June 2016 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP to increase by 1.6% in 2016 and 1.7% in 2017 and 2018. Compared with the March 2016 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised up for 2016 and has remained broadly unchanged for 2017 and 2018. In the Governing Council’s assessment, the risks to the euro area growth outlook remain tilted to the downside, but the balance of risks has improved on the back of the monetary policy measures taken and the stimulus still in the pipeline. Downside risks continue to relate to developments in the global economy, to the upcoming British referendum on EU membership and to other geopolitical risks.

According to Eurostat’s flash estimate, euro area annual HICP inflation in May 2016 was -0.1%. This low level of inflation reflects past falls in energy prices. Looking ahead, on the basis of current futures prices for oil, inflation rates are likely to remain very low or negative in the next few months before picking up in the second half of 2016, in large part owing to base effects in the annual rate of change in energy prices. Supported by the ECB’s monetary policy measures and the expected economic recovery, inflation rates should recover further in 2017 and 2018.

The June 2016 Eurosystem staff macroeconomic projections for the euro area foresee annual HICP inflation at 0.2% in 2016, 1.3% in 2017 and 1.6% in 2018. In comparison with the March 2016 ECB staff macroeconomic projections, the outlook for HICP inflation has been revised slightly up for 2016, reflecting recent oil price increases, and has remained unchanged for 2017 and 2018.

The monetary policy measures in place since June 2014 have clearly improved credit flows across the euro area. Broad money growth decreased somewhat in April, but remained robust. Loan growth continued to recover gradually. Domestic sources of money creation were again the main driver of broad money growth. Low interest rates, as well as the effects of the ECB’s targeted longer-term refinancing operations (TLTROs) and the expanded asset purchase programme (APP), continue to support money and credit dynamics. Banks have been passing on their favourable funding conditions in the form of lower lending rates, and the recovery in loan growth is still drawing strength from improved lending conditions. The total annual flow of external financing to non-financial corporations is estimated to have increased moderately in the first quarter of 2016. Overall, the monetary policy measures in place since June 2014 have improved borrowing conditions for firms and households substantially and the comprehensive package of new monetary policy measures adopted in March this year underpins the ongoing upturn in loan growth, thereby supporting the recovery of the real economy.

Monetary policy decisions

The Governing Council assessed that a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed the need to preserve an appropriate degree of monetary accommodation in order to secure a return of inflation rates towards levels that are below, but close to, 2% without undue delay. The Governing Council decided to keep the key ECB interest rates unchanged and continued to expect these rates to remain at present or lower levels for an extended period of time, and well past the horizon of the Eurosystem’s net asset purchases. Regarding non-standard monetary policy measures, the Governing Council confirmed that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. On 8 June the Eurosystem started making purchases under the CSPP. Moreover, on 22 June the Eurosystem will conduct the first operation of TLTRO II. 

External environment

The subdued global growth recorded towards the end of last year persisted into the first quarter of 2016. Looking ahead, global activity is expected to continue to expand at a moderate pace. Low interest rates, improving labour market conditions and growing confidence support the outlook for advanced economies. By contrast, the outlook for emerging market economies remains more uncertain as growth in China decelerates and commodity-exporting countries adjust to lower commodity prices.

Global economic activity and trade

The global economy continues to expand at a moderate pace. Activity indicators have stabilised, suggesting a continued steady trajectory for the global economy. In financial markets, sentiment has rebounded. Nonetheless, uncertainties continue to cloud the horizon as countries navigate the effects of a number of developments currently shaping the international environment, such as low commodity prices adversely impacting commodity exporters; the tightening of financial conditions, mostly in emerging market economies, partly associated with the normalisation of US monetary policy; the gradual rebalancing of the Chinese economy; and geopolitical risks, including the upcoming British referendum.

Commodity prices have rebounded over the last three months. The price of Brent crude oil has bottomed out following the 12-year low recorded in January. Non-oil commodity prices have also increased in the same period. The recent rise in oil prices reflects a combination of weaker supply and stronger demand. Global oil supply remained rather flat in March and April as OPEC output increased, while non-OPEC output declined, particularly in the United States. At the same time, the International Energy Agency raised its forecast for growth in global oil demand in the first quarter of 2016, but left the growth estimate for 2016 unchanged. From a longer-term perspective, however, oil prices remain substantially below the peaks of 2014. As Box 1 discusses, the anticipated boost to global activity from the pronounced slump in oil prices has been more muted than expected. One factor behind this outcome is that the drivers of the oil price decline have changed over time. While most of the early oil price decline in 2014 was explained by the strong rise in oil supply, subsequent falls appear to have reflected weakening global demand.

Monetary policies in advanced economies remain highly accommodative. Having flattened during January, the Federal Funds Futures curve has shifted upwards. With interest rates expected to remain low for an extended period of time in other major economies, the prospect of policy divergence among advanced economies has increased.

The subdued global growth towards the end of last year persisted into early 2016. GDP growth moderated in the first quarter in the United States and the United Kingdom, although it rebounded somewhat in Japan. On average, activity in other non-euro area European economies also weakened. The data for emerging market economies have been more mixed. In China, macroeconomic data remain consistent with a gradual slowdown, with activity supported by a rebound in the property sector and robust infrastructure spending in the first quarter. Russia has remained in deep recession, although there are signs that the economy is bottoming out as it benefits from higher oil prices. By contrast, the strong downturn in Brazil has continued amid high political uncertainty.

While survey indicators of global economic activity have stabilised, trade growth has lost significant momentum. Following its lowest reading in more than four years in February, the global composite output Purchasing Managers' Index (PMI), excluding the euro area, recovered somewhat in April (see Chart 1). However, OECD composite leading indicators also point to a loss of growth momentum in advanced and emerging economies. Global trade growth turned negative again at the start of 2016. The volume of global imports of goods fell by 1.8% in the first quarter of the year. Estimates of trade volumes were revised sharply downwards for January and February (see Chart 2). Although advanced economies still reported positive import growth, trade was very weak in emerging market economies, particularly in emerging Asia. The negative reading for the first quarter of 2016 followed two consecutive quarters of relatively strong import growth. Base effects related to a particularly weak figure for January may point to improved momentum in the coming months, but surveys continue to suggest a subdued outlook for global trade, with the global PMI for new export orders decreasing in April.

Looking ahead, global economic activity is expected to continue to expand at a moderate pace, driven by still-resilient growth prospects in most advanced economies and the progressive easing of the deep recessions in some large emerging market economies. Continued low interest rates, improving labour market conditions and growing confidence are expected to support the outlook for advanced economies. By contrast, the outlook for emerging market economies remains more uncertain. The gradual deceleration of the Chinese economy is likely to weigh on growth in other emerging market economies, particularly in emerging Asia. Nevertheless, the gradual recovery of Russia and Brazil from deep recessions should support global growth.

Looking at individual countries in more detail, after moderating in the first quarter of the year, economic activity in the United States is expected to rebound. Domestic fundamentals remain supportive – reflected in strong job growth, rising nominal wages and an increase in real disposable income – with domestic demand expected to continue as the main driver of the US growth outlook. Activity should gradually gain traction, supported by more robust consumption and the end of the adjustment in the energy sector. On the other hand, net exports are likely to remain a drag on activity given the past strengthening of the US dollar and weak growth in foreign demand. At the same time, although credit spreads have declined somewhat, interest rates have risen.

Economic activity in the United Kingdom continues to grow steadily. A moderate recovery in activity is expected, driven primarily by consumption as low energy prices continue to raise real disposable incomes. Although lower than in previous years, investment growth remains positive, supported by easing credit conditions. However, growth is potentially constrained by the uncertainty surrounding the referendum on EU membership.

The outlook for Japan remains subdued. Following the decline in activity in the final quarter of 2015, GDP rebounded in the first quarter of this year. Looking ahead, activity should benefit from accommodative monetary policy and the boost to incomes from lower oil prices. A gradual rise in real wages, reflecting the tightening labour market, should also support household spending. Exports are expected to benefit from gradually improving foreign demand, but this will be tempered by the recent rebound of the yen. Moreover, fiscal consolidation will weigh on demand.

Real economic activity in central and eastern Europe – albeit uneven across countries – is projected to remain robust. The main drivers of growth in the region continue to be dynamic private consumption – reflecting higher real disposable income in the low inflation environment – and strong investment growth supported by EU structural funds.

The Chinese economy is expected to slow in the medium term. Activity continues to be supported by low oil prices, robust consumption and a marked improvement in the housing market. Greater stability in financial markets and the renminbi (effective) exchange rate have helped to alleviate some of the uncertainty, which was particularly high at the start of the year. In the near term, monetary accommodation and fiscal stimulus is expected to provide some support for the economy. In the medium term, however, increasing emphasis on reducing overcapacity in some heavy industries and dealing with the related non-performing loans are expected to slow the pace of expansion.

Commodity-exporting countries continue to adjust to the sustained decline in commodity prices. In Russia, still in the midst of a deep recession, funding costs remain elevated despite the easing of financing conditions during 2015. Uncertainty is high, business confidence is weak and lower oil revenue continues to keep public expenditure depressed. Looking ahead, weak positive growth is expected to return only in the second half of 2016, while in 2017 the economy is projected to grow at around its potential rate. In Brazil, political uncertainty, deteriorating terms of trade, and tightening monetary policy and financing conditions are weighing heavily on economic activity. Looking ahead, growth is projected to recover somewhat from the deep recession, as commodity prices stabilise and the drag on investment in commodity sectors moderates.

Overall, the outlook for global growth remains one of a gradual and uneven recovery. According to the June 2016 Eurosystem staff macroeconomic projections, world real GDP growth excluding the euro area is projected to accelerate from 3.1% in 2016 to 3.7% in 2017 and 3.8% in 2018. Euro area foreign demand is expected to increase from 2.0% in 2016 to 3.5% in 2017 and 4.0% in 2018. The modest pick-up in activity and trade foreseen in the baseline scenario reflects resilient growth in advanced economies and a progressive easing of the deep recessions in large emerging market economies, namely Russia and Brazil, over the projection horizon, offsetting the gradual slowdown in the Chinese economy. Compared with the March projections, the outlook for world growth has been revised slightly downwards. Revisions to euro area foreign demand are broadly in line with those to world growth.

Risks to the outlook for global activity remain on the downside, most prominently for emerging market economies. A key downside risk is a stronger slowdown in emerging market economies, including China. Tightening financing conditions and heightened political uncertainty may exacerbate existing macroeconomic imbalances, denting confidence and slowing growth more than expected. Policy uncertainty surrounding the economic transition in China may lead to an increase in global financial volatility. Geopolitical risks also continue to weigh on the outlook, including the upcoming British referendum. Finally, persistently low oil prices may aggravate fiscal or financial imbalances in some oil-exporting countries.

Global price developments

The effects of past oil price declines continue to weigh on global headline inflation. Annual consumer price inflation in the OECD area fell to 0.8% in March, from 1.0% in February, as the drag from falling energy prices increased (see Chart 3). Excluding food and energy, OECD annual inflation has remained unchanged at 1.9% since December. Among large emerging market economies, inflation remains high in Brazil but has fallen in Russia, as the effects of past depreciation of the rouble have waned. In China, inflation has risen slightly on the back of a temporary increase in food prices.

Global inflation is expected to remain subdued in the short term, before rising slowly from the second half of 2016 onwards. The fall in the prices of oil and other commodities at the start of the year – the recent rebound notwithstanding – should dampen inflation rates further in the short term. Looking ahead, the upward sloping oil futures curve implies increases in oil prices over the projection horizon. At the same time, abundant spare capacity at the global level is expected to weigh on underlying inflation over the medium term.

Financial developments

Between early March and early June euro area financial markets returned to more stable conditions relative to those prevailing at the beginning of 2016, just like their counterparts at the global level. Better than expected global economic conditions, a further recovery in oil prices and additional monetary stimulus in the euro area supported market valuations of risky assets. Euro area equity prices increased moderately over the review period, i.e. between 9 March and 1 June 2016, while the announcement of corporate sector asset purchases by the Eurosystem significantly reinforced the decline in spreads on bonds issued by non-financial corporations (NFCs). Yields on long-term euro area sovereign bonds declined somewhat, closely mirroring movements in global long-term yields. In foreign exchange markets, the euro strengthened modestly.

In contrast to the developments observed at the beginning of the year, financial markets across the euro area – and the world as a whole – experienced a period of relative tranquillity between early March and early June 2016, following improvements in the global economy and further increases in the price of oil. These improvements continued a trend that had started in the middle of February on the back of positive economic data releases in the United States, a recovery in oil prices, and expectations of further monetary stimulus in the euro area. The concomitant improvement in global financial market sentiment and decline in financial market volatility continued after the Governing Council announced additional easing measures at its meeting in March. Overall, these developments helped stock markets in most advanced economies to recoup the losses incurred since the start of the year, while corporate bond spreads narrowed. In emerging markets, sovereign bond spreads became smaller, with most countries experiencing an improvement in external financing conditions (see Chart 4).

The euro overnight index average (EONIA) declined during the review period, following the Governing Council’s decision to cut the deposit facility rate by 10 basis points to -0.40% on 10 March. The EONIA fell by 9.7 basis points during the review period (9 March to 1 June), reflecting a complete pass-through of the decrease in the deposit facility rate. Since the start of the second reserve maintenance period of 2016, when the rate cut took effect, the EONIA has remained in a range between -32 and -36 basis points, except for at the end of the first quarter, when it temporarily rose to -30 basis points. Excess liquidity increased by €144 billion, to around €845 billion, in the context of Eurosystem purchases under the expanded asset purchase programme (see also Box 2).

Amid the low overall volatility, changes in the EONIA forward curve were limited, with some declines in the middle segment of the curve. At the short end, the curve moved marginally upwards over the review period, largely reflecting financial markets’ upward revision of short-term forward rates in the euro area on the day of the Governing Council’s meeting in March. In the middle segment, the curve shifted downwards somewhat, suggesting that market participants were expecting the key ECB interest rates to stay lower for longer. By contrast, longer-term EONIA forward rates were virtually unchanged between early March and early June (see Chart 5).

Yields on long-term euro area government bonds declined somewhat over the review period, closely mirroring movements in global long-term yields. In March sovereign yields were on a downward trajectory, with the GDP-weighted average of ten-year euro area government bond yields reaching an all-time low of 0.75% on 1 April 2016. Euro area long-term yields increased thereafter, but repeated declines set in from late April. These declines in long-term spot rates were consistent with the decrease in medium-term EONIA forward rates and saw the GDP-weighted ten-year yield end the review period 11 basis points below its level on 9 March (see Chart 6). Overall, the declines in yields were marginally more pronounced for higher-rated euro area countries, but there were significant reductions in Greek sovereign bond yields in the context of the Eurogroup’s extension of loans to Greece. While euro area long-term yields generally moved closely in line with their global counterparts, long-term bond yield spreads between the United States and the euro area widened, mainly reflecting market perceptions of increased divergence of the monetary policies of the two economies.

Following the Governing Council’s announcement of the corporate sector purchase programme (CSPP), spreads on bonds issued by non-financial corporations declined significantly. The announcement of the CSPP in March reinforced a narrowing of NFC bond spreads that had been ongoing amid the improvement in global market sentiment from mid-February. Spreads then continued to decline gradually, including after the release of the CSPP implementation details at the Governing Council’s meeting in mid-April, before widening slightly in the course of May. On balance, NFC bond spreads in early June were significantly lower than in early March (see Chart 7). While spreads on bank bonds followed a similar pattern, their reductions were relatively more muted.

Euro area stocks recorded moderate gains amid low market volatility. The broad EURO STOXX index increased by around 2% between 9 March and 1 June 2016. This compares with the circa 6% rise made by the S&P 500 index in the United States (see Chart 8). Euro area bank equity prices decreased by around 2%. Moreover, the prices of euro area bank stocks experienced more pronounced swings in both directions than the wider market as profitability concerns, as well as country and bank-specific events, continued to weigh on the sector.

In foreign exchange markets, the euro strengthened modestly in effective terms. The currency appreciated between early March and late April, largely reflecting evolving market expectations regarding monetary policy stances across major economies. It was also supported by improved market sentiment towards the euro following better than expected data on economic activity in the euro area. From early May the euro weakened in effective terms, also against the US dollar amid the widening of long-term bond yield spreads between the United States and the euro area. Overall, the euro strengthened by 1.2% in trade-weighted terms from 9 March to 1 June (see Chart 9). In bilateral terms, the euro appreciated against the US dollar, the Chinese renminbi, the Swiss franc and the currencies of many emerging market economies, as well as the currencies of most central and eastern European countries. It weakened against the Russian rouble, the Japanese yen and the currencies of some commodity-exporting countries.

Economic activity

Euro area real GDP increased significantly in the first quarter of 2016 and growth continues to be supported by domestic demand, while being dampened by weak exports. The latest data point to ongoing growth in the second quarter, though possibly at a lower rate than in the first quarter. Looking ahead, the economic recovery is expected to proceed at a moderate but steady pace. Domestic demand remains supported by the pass-through of the ECB’s monetary policy measures to the real economy. Favourable financing conditions and improvements in corporate profitability continue to promote investment. Moreover, sustained employment gains, which are also benefiting from past structural reforms, and still relatively low oil prices provide additional support for households’ real disposable income and private consumption. In addition, the fiscal stance in the euro area is slightly expansionary. However, the economic recovery in the euro area continues to be dampened by subdued growth prospects in emerging markets, the necessary balance sheet adjustments in a number of sectors and a sluggish pace of implementation of structural reforms. The June 2016 Eurosystem staff macroeconomic projections foresee euro area real GDP growing by 1.6% in 2016 and by 1.7% in 2017 and 2018.

Economic growth in the euro area strengthened in the first quarter of 2016 and the level of real GDP has now surpassed its peak in 2008 (see Chart 10). Real GDP growth came out stronger than in the previous quarter in many euro area countries and seems to have been supported by continued positive contributions from private consumption and also investment, which nonetheless remains far below its peak level seen before the crisis. Net exports are likely to have continued to be a drag on growth in the first quarter of 2016, on account of the subdued growth in global trade.

Private consumption dynamics seem to have held up in the first quarter of 2016 and this component remains the main driver of the ongoing recovery. Despite a fall in March, retail sales and car registrations rose by 1%, quarter on quarter, in the first quarter, following a temporary slowdown in the fourth quarter of 2015, reflecting lower sales of seasonal clothing and lower energy consumption due to the mild winter, as well as adverse impacts stemming from the November terrorist attacks in Paris. From a longer perspective, consumer spending has benefited from rising real disposable income among households, which in turn primarily reflects rising employment but also lower oil prices (see Chart 11) and a fairly stable savings ratio. Moreover, while euro area households’ interest earnings have declined since 2008, their net interest earnings have been fairly stable. With redistribution from net savers to net borrowers, interest income should continue, on balance, to support private consumption (see Box 3 entitled “Low interest rates and households’ net interest income”). Furthermore, households’ balance sheets have gradually become less constrained and consumer confidence has regained strength on the back of the continued decline in the unemployment rate.

Further improvements in euro area labour markets lend support to private consumption via aggregate labour income. Employment increased further, rising by 0.3%, quarter on quarter, in the fourth quarter of 2015. As a result, employment stood 1.2% above the level recorded one year earlier, which represents the highest annual increase since the second quarter of 2008. Meanwhile, the unemployment rate stood at 10.2% in April, the lowest rate since August 2011, having declined consistently since mid-2013. More timely information such as surveys point to ongoing moderate improvements in euro area labour markets. Notwithstanding these positive developments, wider measures of unemployment – which also take into account sections of the working age population involuntarily working part-time or which have withdrawn from the labour market – remain high, however. Roughly 4% of the labour force is currently involuntarily working part-time owing to a lack of full-time work and a similar proportion is discouraged and is not actively seeking work. Thus, the euro area labour market is likely to be characterised by substantially more slack than suggested by the unemployment rate alone.

Following an increase in capacity utilisation in the manufacturing sector and overall strong growth in capital goods production, investment growth is likely to have continued at the robust pace seen at the turn of the year. Demand conditions have also improved and are thus supporting business investment. Since 2013, for example, demand has become less frequently mentioned in the European Commission’s survey as a factor limiting production (see Chart 12). Residential investment, on the other hand, was likely to have been supported by favourable weather conditions in the first quarter, but also by the strengthening of housing markets more generally as evidenced by increases in applications for building permits and demand for mortgages. Looking ahead, demand for residential property should be further bolstered by low mortgage rates and growth in households’ disposable income, as well as by some search for yield in an environment where the return on alternative assets is low. Improving financing conditions, rising profits and ample cash reserves among euro area firms, combined with gradually improving domestic and external demand, are also expected to support business investment going forward. Nevertheless, the recovery in total investment may be dampened by the further need for corporate deleveraging in some countries, investors’ reduced long-term growth expectations and subdued growth prospects in emerging market economies.

The downward trend in goods export growth seems to have continued in the first quarter of 2016 following subdued global trade developments (see Chart 13). Important export destinations such as the United States, but also Switzerland and Japan contributed negatively to export growth and exports to the United Kingdom grew less than in the last quarter of 2015. Among the large emerging market economies, weak demand in Brazil and Russia remained a drag on goods export growth, while the contribution of China was broadly neutral after having been negative during 2015.

Export growth is expected to increase only modestly in the short term, amid continuing weak global trade dynamics. Export orders as well as sentiment among exporters point to continued subdued external trade developments in the near term and recent movements in the effective exchange rate of the euro are not providing any relief. However, export market shares are expected to remain elevated owing to the lagged effects of previous gains in competitiveness. Looking further ahead, euro area export growth is expected to gradually pick up in line with euro area foreign demand.

Overall, available short-term indicators point to ongoing moderate growth in the second quarter of 2016. The European Commission’s Economic Sentiment Indicator (ESI) rose in April and May, while the composite output Purchasing Managers’ Index (PMI) edged down (see Chart 14), with both indicators remaining above their long-term average levels. Industrial production (excluding construction) declined in February and March, however, signalling some downside risks to quarterly production growth in the second quarter owing to the associated negative carry-over effects.

Looking further ahead, the economic recovery in the euro area is expected to proceed, supported by the pass-through of the ECB’s monetary policy measures to the real economy. Investment should also be promoted by further improvements in corporate profitability, while consumer spending is expected to be sustained by ongoing employment gains alongside the still relatively low price of oil. However, the economic recovery continues to be dampened by subdued growth prospects in emerging markets.

The June 2016 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 1.6% in 2016 and 1.7% in 2017 and 2018 (see Chart 15). Compared with the March 2016 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised up for 2016 and has remained broadly unchanged for 2017 and 2018. The risks to the euro area growth outlook remain tilted to the downside, but the balance of risks has improved on the back of the monetary policy measures taken and the stimulus still in the pipeline. Downside risks continue to relate to developments in the global economy, to the upcoming British referendum on EU membership and to other geopolitical risks.

Prices and costs

According to Eurostat's flash estimate, euro area annual HICP inflation was -0.1% in May. This low inflation rate reflects past falls in energy prices. Looking ahead, on the basis of current futures prices for oil, inflation rates are likely to remain very low or negative in the next few months before picking up in the second half of 2016, in large part owing to base effects in the annual rate of change of energy prices. Supported by the ECB’s monetary policy measures and the expected economic recovery, inflation rates should recover further in 2017 and 2018. This broad pattern is also reflected in the June 2016 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 0.2% in 2016, 1.3% in 2017 and 1.6% in 2018. Compared with the March 2016 ECB staff macroeconomic projections, the outlook for HICP inflation remains broadly stable.

Headline inflation increased slightly in May, but remained in negative territory. According to Eurostat's flash estimate, the annual rate of HICP inflation increased to -0.1% in May, from -0.2% in April, driven mainly by higher energy price inflation and somewhat higher services price inflation (see Chart 16). Owing to the increase in services price inflation from 0.9% in April to 1.0% in May, HICP inflation excluding food and energy increased from 0.7% in April to 0.8% in May.

Energy prices continue to be a major drag on headline inflation. For almost one-and-a-half years, the negative contribution of energy price inflation has ranged between 0.5 and 1 percentage point (see Chart 16). Oil prices in (US) dollars have been rising since a low in January 2016 but are still well below the levels observed a year ago. Therefore the recent price increases have only contributed slightly to containing the negative contribution of energy prices to headline inflation, as HICP energy price inflation still stood at a very low level of -8.1% in May 2016. The impact of the recent upward movement in oil prices will become clearer once the earlier strong declines drop out of the annual inflation rate calculation. The associated upward impacts of the resulting base effects explain most of the expected rise in headline HICP inflation over the coming period until early 2017 (see Chart 17).

Underlying inflation fails to show any clear upward trend. This is corroborated by a broad range of alternative measures of underlying inflation (see Chart 18). Following an upward movement in the first half of 2015, HICP inflation excluding food and energy hovered between year-on-year rates of 0.8% and 1.1% from July 2015 to March 2016. Its movement recently has been quite volatile, with the annual rate of change increasing from 0.8% in February to 1.0% in March but then falling back to 0.7% in April. This movement resulted primarily from developments in services price inflation, which increased from 0.9% in February, to 1.4% in March 2016, but then returned to 0.9% in April. The recent volatility in HICP inflation excluding food and energy can therefore largely be explained by a calendar effect. Easter occurred in March this year and in April last year, pushing the annual services price inflation rate up in March 2016 and down in April 2016, particularly for travel-related items such as package holidays. When looking at an HICP measure which excludes, in addition to food and energy, items such as travel, and clothing and footwear – which can be strongly affected by calendar effects – the underlying inflation trend is far more stable but shows no clear signals of upward momentum.

The import price inflation rate turned negative and producer price pressures have remained subdued. In 2015 import price inflation in consumer goods excluding food and energy was buoyant, reaching a record high of 5.6% in April of that year. Due to the recent appreciation of the effective exchange rate of the euro and also to the impact of global disinflationary pressures stemming from lower oil prices, this rate has since fallen and, at -0.5%, entered negative territory in March (see Chart 19). The impact of decelerating import prices is evident in the durable goods component of HICP inflation, which saw strong upward momentum that is now continuing to lose its vigour. Inflation rates in other components of the HICP consumer goods sub-indices with relatively high import content, such as semi-durables, have also declined recently. This direct impact of the effective exchange rate of the euro via imported consumer goods should be distinguished from the overall effects of exchange rate movements working through the production and pricing chain. As these take several quarters to fully materialise, the past depreciation of the euro exchange rate is also still passing through. However, for the time being, the annual inflation rate of domestic producer prices for non-food consumer goods has also remained subdued, at -0.1% in March (unchanged from February). Survey data on input and output prices for the period up to May 2016 point to a continuation of low price pressures at the producer level.

Wage pressures remain subdued. Negotiated wage growth decreased slightly to 1.4% in the first quarter of 2016, compared with a rate of 1.5% in the fourth quarter of 2015, and for 2015 as a whole.  Wage growth is likely being held back by a range of factors including: continued elevated levels of slack in the labour market; relatively weak productivity growth associated with a large number of jobs being created in services sectors with relatively low productivity; low inflation; and the ongoing effects of labour market reforms implemented in past years in a number of euro area countries.^[1]

Market-based measures of long-term inflation expectations have continued to stabilise, but remain at levels substantially below those of survey-based expectation measures. The five-year forward inflation rate five years ahead has increased recently to stand somewhat higher than its all-time low at the end of February (see Chart 20). However, looking at a longer historical period, market-based measures of inflation remain at low levels. This partly reflects an indication that market participants consider inflation unlikely to pick up soon. At the same time, it also reflects current inflation risk premia that are most likely slightly negative, suggesting that market-based indicators of inflation tend to underestimate future inflation somewhat. Despite the low level of actual inflation and of market-based inflation expectation indicators, the deflation risk priced in by the market continues to be very limited. In contrast to market-based measures, survey-based measures of long-term inflation expectations, such as those included in the ECB Survey of Professional Forecasters (SPF) and in Consensus Economics surveys, have been far more stable and resilient to the downward adjustment of shorter-term expectations. According to the results of the latest SPF, the average point forecast for inflation five years ahead stands at 1.8%, unchanged from the previous survey, and the downside risk to this mean expectation appears to have decreased slightly.

Looking forward, HICP inflation for the euro area is projected to be low in 2016 but to pick up in 2017 and 2018. Based on the information available in mid-May, the June 2016 Eurosystem staff macroeconomic projections for the euro area foresee an HICP inflation rate of 0.2% in 2016, rising to 1.3% in 2017 and 1.6% in 2018 (see Chart 17).^[2] Over the projection horizon, developments in energy price inflation are expected to play a major role in shaping the profile of HICP inflation. The contribution of energy price inflation is forecast to turn positive in 2017 as a result, in particular, of strong upward base effects. Underlying inflation (as measured, for example, by HICP inflation excluding food and energy) is expected to increase gradually in the coming years as improving labour market conditions and declining economic slack translate into higher wages and profit margins. This increase will be supported by the effects of the ECB’s monetary policy measures and the continuing pass-through of previous declines in the effective exchange rate of the euro. Compared with the March 2016 ECB staff macroeconomic projections for the euro area, the outlook for HICP inflation remains broadly stable.

Money and credit

Money growth decreased somewhat in April, but remained robust. At the same time, loan growth continued to recover gradually. Domestic sources of money creation were again the main driver of broad money growth. Low interest rates, as well as the effects of the ECB’s targeted longer-term refinancing operations (TLTROs) and the expanded asset purchase programme (APP), continue to support money and credit dynamics. Banks have been passing on their favourable funding conditions in the form of lower lending rates, and the recovery in loan growth is still drawing strength from improved lending conditions. The total annual flow of external financing to non-financial corporations (NFCs) is estimated to have increased moderately in the first quarter of 2016.

Broad money growth decreased somewhat, but remained robust. The annual growth rate of M3 moderated to 4.6% in April 2016, after having hovered around 5.0% since May 2015 (see Chart 21). Broad money growth was once again supported by the most liquid components. M1 has recently been showing signs of deceleration as its annual growth rate also decreased in April 2016, though remains at a high level. Overall, recent developments in narrow money still confirm that the euro area remains on a path of gradual economic recovery.

Overnight deposits, which account for a significant proportion of M1, continued to boost M3 growth (see Chart 22). The very low interest rate environment is providing incentives for holding the most liquid components of M3. This development reflects inflows relating to the sale of public sector bonds, covered bonds and asset-backed securities by the money-holding sector in the context of the APP. By contrast, short-term deposits other than overnight deposits (i.e. M2 minus M1) contracted further in the first quarter of 2016 and in April. In addition, the growth rate of marketable instruments (i.e. M3 minus M2), a small component of M3, continued to decline in the first quarter of 2016 and in April, despite the ongoing recovery in money market fund shares/units.

Domestic sources of money creation were again the main driver of broad money growth. Among these, credit to general government remained the most important factor behind money creation, while credit to the private sector displayed a gradual recovery. The former trend reflects the ECB’s non-standard monetary policy measures, including the public sector purchase programme (PSPP). A significant percentage of the assets acquired under the PSPP were purchased from monetary financial institutions (MFIs) (excluding the Eurosystem). MFIs’ longer-term financial liabilities (excluding capital and reserves) – the annual rate of change of which has been negative since June 2012 – decreased at a slightly lower rate in April 2016. This reflects the flatness of the yield curve, linked to the ECB’s non-standard measures, which has reduced incentives for investors to hold longer-term bank instruments. The attractiveness of the TLTROs as an alternative to longer-term market-based bank funding is a further explanatory factor. Meanwhile, the MFI sector’s net external asset position remained a drag on annual M3 growth, partly owing to capital outflows from the euro area and the ongoing portfolio rebalancing in favour of non-euro area instruments; a trend which can be explained by euro area government bonds sold by non-residents via the PSPP.

Loan dynamics recovered gradually, but bank lending was still weak. Credit growth improved moderately for both firms and households. The annual growth rate of MFI loans to the private sector increased in the first quarter of 2016 and remained stable in April (see Chart 21). While the annual growth rate of loans to NFCs stayed subdued (see Chart 23), it has recovered substantially from the trough of the first quarter of 2014. This improvement is broadly shared by the largest countries, though loan growth rates are still negative in some jurisdictions. In comparison, the annual growth rate of loans to households (adjusted for sales and securitisation) picked up slightly in the first quarter of 2016 and remained broadly unchanged in April (see Chart 24). The significant decreases in bank lending rates seen across the euro area since summer 2014 (notably owing to the ECB’s non-standard monetary policy measures) and improvements in the supply of, and demand for, bank loans have supported these trends. However, the ongoing consolidation of bank balance sheets and persistently high levels of non-performing loans in some countries continue to curb loan growth.

Changes in credit standards and loan demand once again contributed to improving loan growth. The April 2016 euro area bank lending survey identified a number of important factors behind increasing loan demand, including the low general level of interest rates, financing needs for fixed investment and favourable housing market prospects (see survey at: https://www.ecb.europa.eu/stats/money/surveys/lend/html/index.en.html). In this context, the expanded asset purchase programme had a net easing impact on credit standards and particularly on credit terms and conditions. Banks also reported that the additional liquidity from the APP and the TLTROs was mainly used to grant loans. At the same time, euro area banks reported that the APP has had a negative impact on their profitability. Despite the positive developments mentioned, loan growth remained weak, again reflecting factors such as subdued economic conditions and the consolidation of bank balance sheets. Moreover, in some parts of the euro area, tight lending conditions are still weighing on loan supply.

Banks’ funding costs have stabilised close to their historical lows. The composite cost of bank funding has been declining for a number of years (see Chart 25) against the backdrop of net redemption of MFIs’ longer-term financial liabilities. In general, the ECB’s accommodative monetary policy stance, a strengthening of balance sheets and receding fragmentation across financial markets have supported the decrease in banks’ composite funding costs. Meanwhile, as regards banks’ access to funding, the April 2016 euro area bank lending survey shows that, with the exception of securitisation, no further improvements were noticeable in the first quarter of 2016 for the other major market instruments.

Bank lending rates for the private sector have declined further (see charts 26 and 27). Composite lending rates for NFCs and households have decreased by significantly more than market reference rates since June 2014. Receding fragmentation in euro area financial markets and the improvement in the pass-through of monetary policy measures to bank lending rates have played a positive role here. Furthermore, the decrease in banks’ composite funding costs has supported the decline in composite lending rates. Since June 2014, banks have been progressively passing on the decline in their funding costs in the form of lower lending rates. Between May 2014 and March 2016, composite lending rates on loans to both euro area NFCs and households fell by more than 80 basis points – vulnerable euro area countries have seen particularly strong reductions in bank lending rates. Over the same period, the spread between interest rates charged on very small loans (loans of up to €0.25 million) and those charged on large loans (loans of above €1 million) in the euro area followed a downward path. This generally indicates that small and medium-sized enterprises are benefiting to a greater extent than large companies from the decline in lending rates.

The total annual flow of external financing to euro area NFCs is estimated to have increased moderately in the first quarter of 2016. NFCs’ external financing still stands below the levels observed in early-2012 (the post-financial crisis peak) and end-2004 (before the period of excessive credit growth). The recovery in NFCs’ external financing seen since early-2014 has been supported by the improvement in economic activity, further declines in the cost of bank lending, the easing of bank lending conditions and the very low cost of market-based debt. Meanwhile, NFCs further increased their cash holdings in the first quarter of 2016, bringing these to a new historical high – a development related to remaining concerns about the strength of the global recovery and low opportunity costs.

NFCs’ net issuance of debt securities rose strongly in March 2016, after contracting in January and February. The March increase was mostly a product of special factors and resulted in a positive flow for the quarter as a whole. Market data show that issuance activity grew modestly in April and May, being supported, inter alia, by the ECB’s monetary policy package of March 2016. The net issuance of quoted shares by NFCs remained subdued in the first quarter of 2016.

The overall nominal cost of external financing for euro area NFCs has decreased slightly since March 2016, reaching a new historical low. This decline is mainly explained by the fall in the cost of equity financing and, to a lesser extent, by the reduction in the cost of market-based debt financing. These developments were supported by positive economic news, the announcement of the ECB’s March monetary policy package, as well as the global phenomenon of declining yields.

Fiscal developments

The euro area budget deficit is projected to further decline over the projection horizon (2016-18) mainly as a result of improving cyclical conditions and decreasing interest payments. The aggregate fiscal stance for the euro area is projected to be expansionary in 2016, but to tighten somewhat in the period 2017-18, notwithstanding large cross-country differences. In a number of Member States the expected fiscal stance implies risks of non-compliance with the Stability and Growth Pact (SGP). In particular the countries with high debt levels would need additional consolidation efforts to set their public debt ratio firmly on a downward path.

The euro area general government budget deficit is projected to decline over the projection horizon. Based on the June 2016 Eurosystem staff macroeconomic projections^[3], the general government deficit ratio for the euro area is expected to decline from 2.1% of GDP in 2015 to 1.4% of GDP in 2018 (see the table). The fiscal outlook has improved slightly over the projection horizon, compared with the March 2016 projections. The improvement is mainly due to a better macroeconomic outlook and lower interest payments, while changes to discretionary fiscal policy are expected to be limited. The projections are less optimistic than what the euro area countries outlined in their 2016 updates of the stability programmes, which also include fiscal measures that are not yet legislated for nor fully specified.

The euro area fiscal stance is projected to be expansionary in 2016, but to tighten somewhat in the period 2017-18.^[4] The loosening of the aggregate fiscal stance in 2016, which can be viewed as broadly appropriate in the light of the remaining amount of slack in the economy, reflects the impact of discretionary fiscal measures, such as cuts in direct taxes and social security contributions in a number of euro area countries. The slightly tighter fiscal stance in the period 2017-18 is expected to result from restraint in government spending, which will outweigh deficit-increasing measures on the revenue side. In particular, compensation of employees and intermediate consumption are projected to grow below nominal trend GDP growth. By contrast, social transfers and government investment are expected to grow above potential. The projected euro area fiscal stance masks large cross-country differences. In the case of those countries for which a fiscal loosening has been projected, the driving factors vary from country to country, ranging from the strong impact of the refugee influx to the impact of tax cuts and budgetary measures affecting the expenditure side.

Euro area government debt will continue to decline from its elevated level. The euro area debt-to-GDP ratio, which peaked in 2014, declined to 90.7% of GDP in 2015 and is projected to gradually decline further to 87.4% of GDP by the end of 2018. The projected reduction in government debt is supported by favourable developments in the interest rate-growth differential, in the light of the better macroeconomic outlook and assumed low interest rates. In addition, small primary surpluses and negative deficit-debt adjustments, inter alia reflecting privatisation receipts, will also contribute to the better debt outlook. Compared with the March 2016 projections, the decline in the aggregate debt-to-GDP ratio for the euro area is expected to be slightly higher, mainly as a result of higher primary surpluses and a more favourable interest rate-growth differential. From a cross-country perspective, while the debt-to-GDP ratio is projected to decline in the majority of euro area countries, there are a few countries for which the government debt ratio is expected to increase over the projection horizon. In particular for the high debt countries, further consolidation efforts are needed to set the public debt ratio firmly on a downward path, as their high debt levels make them particularly vulnerable should there be renewed financial market instability or a rebound in interest rates.

Risks of non-compliance with the SGP are high in a number of countries. Governments need to strike a balance in their fiscal policy stance between reducing high debt levels and not impairing the recovery, while fully complying with the SGP requirements. For countries with fiscal space, it is welcome that they have used it. Yet countries without fiscal space should continue to implement the measures necessary to ensure full compliance with the SGP, thereby addressing debt sustainability risks and increasing resilience to future shocks. The European Commission released on 18 May its proposed country-specific recommendations for economic and fiscal policies for the EU Member States. It also identified risks of non-compliance with the structural consolidation requirements of the SGP for many countries and published recommendations regarding the implementation of the SGP.^[5] To ensure credibility, it is crucial that the fiscal governance framework is applied in a legally sound, transparent and consistent manner across time and countries. Moreover, to increase their room for fiscal manoeuvre, countries should strive for a more growth-friendly composition of fiscal policies.

Boxes

Box 1 Global implications of low oil prices

This box looks at the impact on global activity of the oil price declines during the last two years. Oil prices have fallen sharply since mid-2014 and reached a ten-year low in early 2016. From their peak in June 2014 to the trough in January 2016, Brent crude oil prices dropped by USD 82 per barrel (70%). Since then, they have recovered modestly by around USD 17 per barrel and, based on oil futures contracts, are expected to rise only gradually in the medium term.

The drivers of the recent oil price decline have changed over time. While most of the oil price decline in 2014 could be explained by the significant increase in the supply of oil, more recently the lower price has reflected weaker global demand. On the supply side, significant investment and technological innovations – particularly in shale oil extraction – caused oil production to surge at a time of weakening growth, particularly in energy-intensive emerging market economies, putting downward pressure on oil prices. Meanwhile, OPEC’s decision in November 2014 to keep production quotas unchanged intensified the downward pressures on oil prices amid rising oil inventories. More recently, however, concerns have arisen that weaker global growth has been the main driver of the oil price falls.

The changing nature of the oil price shock has different implications for the global economy. In early 2015 the largely supply-driven fall in oil prices was expected to have a significant net positive impact on global activity, mainly via two channels: (i) income redistribution from oil-producing to oil-consuming countries, which were expected to have a larger marginal propensity to spend; and (ii) profitability gains from lower energy-input costs, which could stimulate investment and thus total supply in net oil-importing countries. However, a more demand-driven oil price fall since the second half of 2015 suggests a less positive impact on the global economy. Although the low oil price may still support domestic demand through rising real incomes in net oil-importing countries, it would not necessarily offset the broader effects of weaker global demand.

Model estimates underscore how the impact on the global economy depends on the underlying nature of the shock. Simulations^[6] suggest that a 10% decline in oil prices that is entirely supply driven increases world GDP by between 0.1% and 0.2%, whereas a 10% decline in oil prices that is entirely demand driven is typically associated with a decrease in world GDP of more than 0.2%. Assuming that, for example, 60% of the oil price decline since mid-2014 has been supply driven and the remainder demand driven, the models suggest that the combined impact of these two shocks on world activity would be close to zero (or even slightly negative).

The experience of the past year also suggests that changes in the transmission channels may have dampened the expected positive impact of lower oil prices on global activity. Compared with previous episodes of oil price declines in the 1980s and 1990s, the combined effect of several countervailing factors may have altered the propagation mechanisms of the recent oil price shock.

On the one hand, the adverse impact on net oil-exporting countries appears to have been rather severe, and has been accompanied by negative spillovers to other emerging market economies. In several net oil-exporting countries, the oil price decline has interacted with other shocks (including fallout from geopolitical tension) to generate a significant macroeconomic adjustment. Major net oil exporters have managed to cushion, to some extent, the initial adverse impact on their output from the recent oil price decline by running substantial and rising fiscal deficits. Nonetheless, GDP growth in these countries has still declined significantly compared with the rest of the world (see Chart A). With spot crude oil prices falling well below fiscal breakeven prices, i.e. the prices required to balance government budgets (see Chart B), the fiscal situation has become increasingly more challenging in several major oil producers, particularly those with currency pegs to the US dollar or other tightly managed exchange rate arrangements (e.g. Iran, Iraq, Nigeria, Saudi Arabia, the United Arab Emirates and Venezuela). Monetary policy has also been constrained in commodity-exporting countries with more flexible exchange rates (e.g. Canada, Mexico, Norway and Russia). As the currencies of these countries have (sharply) depreciated, inflationary pressures have risen, thereby limiting the room for monetary policy easing in response to slowing growth. Finally, financial strains have exacerbated the downturn in prices, particularly in countries with foreign currency exposures. While the share of major oil-exporting countries in the global economy is relatively small (roughly 15% of global GDP based on purchasing power parity), negative spillovers to countries with close trade or financial links, and global confidence effects, have weighed on global economic activity.

On the other hand, the pickup in demand in several net oil-importing countries as a result of income windfalls from lower oil prices has so far been rather limited. From a longer-term perspective, this could reflect lower energy intensities compared with earlier episodes of oil price declines in the 1980s and the 1990s. In a more recent context, other factors may have restricted the responsiveness of consumption to the oil price decline in some countries, although such effects are often difficult to disentangle empirically. For example, an increase in personal savings in some countries could be related to continued needs for deleveraging that may have prompted households to save more of the windfall gains from lower oil prices than might otherwise have been the case. In addition, expectations may have played a role: spending may build up only gradually if it takes time for households to believe that the lower oil price level will persist. Meanwhile, among emerging market economies, government savings from lower energy subsidies have been used for fiscal consolidation rather than additional economic stimulus. Finally, other factors, such as exchange rate developments and downward adjustments in equity and other asset prices amid increased global economic uncertainty, may have dampened the positive impact of lower oil prices on consumption.

Taking the example of the United States as one of the largest net oil importers, the benefits for consumption of lower oil prices have been smaller than initially anticipated and largely offset by sharp falls in energy-related investment. The oil price decline has supported consumption, but uncertainty about the persistence of low oil prices may have weighed on confidence, implying that the impact of the oil price drop was smaller than initially expected. Meanwhile, the impact of lower oil prices on US shale oil investment was significant, and amplified by the high degree of leverage of shale oil producers and their vulnerability to funding constraints. Since the start of the oil price decline in mid-2014, energy-related investment has dropped cumulatively by 65%, making a negative contribution to GDP growth (see Chart C), while the number of oil rigs has declined to almost one-third of the original number. Yet, in net terms, the estimated impact of the oil price decline on US GDP so far is judged to be modestly positive.

In sum, compared with a year ago, when oil price falls were dominated by supply factors, recent developments suggest that low oil prices have increasingly reflected weakening global demand. While a largely supply-driven fall in oil prices was expected to have a net positive impact on global GDP, a more demand-driven oil price decline is less likely to provide significant support to global activity. Moreover, the assessment of the role of lower oil prices is clouded by a high degree of uncertainty. One factor driving this uncertainty is possible financial stability and fiscal challenges in some commodity-exporting countries. Another factor is concerns of a more general economic slowdown in emerging market economies, fuelled by widening domestic imbalances and tighter financial conditions in some countries.

Box 2 Liquidity conditions and monetary policy operations in the period from 27 January 2016 to 26 April 2016

This box describes the ECB’s monetary policy operations during the first and second reserve maintenance periods of 2016, which ran from 27 January to 15 March and from 16 March to 26 April respectively. On 10 March 2016, the Governing Council announced a comprehensive package of monetary policy decisions, which included a cut in all key ECB interest rates, an expansion of the asset purchase programme in terms of monthly volumes and asset eligibility, plus a series of four new targeted longer-term refinancing operations (TLTROs)^[7]. Thus, during the second maintenance period the interest rates on the main refinancing operations (MROs), the marginal lending facility and the deposit facility were lowered to 0.00%, 0.25% and -0.40% respectively as of 16 March^[8]. On 30 March 2016 the seventh TLTRO was settled for €7.3 billion, compared with €18.3 billion in the previous TLTRO in December 2015. This brought the total allotted amount in the first seven TLTROs to €425.3 billion.^[9] In addition, the Eurosystem continued buying public sector securities, covered bonds and asset-backed securities as part of its asset purchase programme (APP)^[10], with a targeted purchase amount that increased from €60 billion to €80 billion per month in the second maintenance period.

Liquidity needs

In the period under review, the average daily liquidity needs of the banking system, defined as the sum of autonomous factors and reserve requirements, stood at €778.6 billion, an increase of €72 billion compared with the previous review period (i.e. the seventh and eighth maintenance periods of 2015). This greater liquidity need is almost exclusively attributable to an increase in autonomous factors, which rose on average by €71.1 billion to stand at €664.5 billion (see table).

The increase in autonomous factors was mainly a result of an increase in liquidity-absorbing factors. The main contributor to this increase was government deposits, which increased on average by €42.7 billion to stand at €130.3 billion in the period under review. This increase was equally divided between the first and second maintenance periods. The increase in government deposits reflects the reluctance of some treasuries to place their excess liquidity at negative rates in the market, owing to both demand and rate constraints. Other autonomous factors averaged €573.7 billion, up €10.7 billion from the previous review period, mainly reflecting an increase in other liabilities to euro area residents denominated in euro. In addition, banknotes averaged €1,066.1 billion, up €0.9 billion compared with the previous review period, contributing the least to the overall increase in autonomous factors.

Liquidity-providing factors declined over the period on the back of lower net assets denominated in euro. Net assets denominated in euro averaged €489.0 billion, down €22 billion from the previous review period. Most of this fall occurred during the first maintenance period on account of a decline in financial assets held by the Eurosystem for purposes other than monetary policy, together with a small increase in liabilities held by foreign institutions with the national central banks. Foreign institutions increased their holdings despite the further cut to the deposit facility rate, possibly owing to fewer attractive investment alternatives in the market. In addition, net foreign assets increased by €5 billion to stand at €616.8 billion. This increase occurred exclusively in the second maintenance period, while the first maintenance period saw a marginal decline. This appreciation of net foreign assets was mainly driven by an increase in the US dollar value of gold, which was only partially offset by an appreciation of the euro in the first quarter of 2016.

The volatility of autonomous factors remained elevated during the period under review. Such volatility primarily reflected strong fluctuations in government deposits and, to a lesser extent, the quarterly revaluation of net foreign assets and net assets denominated in euro. The level of volatility remained broadly unchanged compared to the previous review period, while the level of autonomous factors continued its upward trend. Still, theaverage absolute error in weekly forecasts of autonomous factors declined by €1.4 billion to €6.0 billion in the period under review, due to lower forecast errors for government deposits.

Liquidity provided through monetary policy instruments

The average amount of liquidity provided through open market operations – both tender operations and the asset purchase programme – increased by €165.3 billion to stand at €1,472.2 billion (see chart). This increase was entirely due to the Asset Purchase Programme.

The average amount of liquidity provided through tender operations declined slightly – by €10.6 billion – during the period under review to stand at €521.9 billion. The increase in average liquidity provided by the TLTROs was more than offset by a decrease in liquidity provided by regular operations. More specifically, the liquidity provided in MROs and the three-month LTROs decreased by €8.4 billion and €14.3 billion respectively, while the outstanding amount of TLTROs increased by €12.1 billion over the review period. As the only TLTRO so far in 2016 was allotted in March, the overall decline in liquidity provided through tender operations was less pronounced in the second maintenance period than in the first.

The average liquidity amount provided through the asset purchase programme increased by €175.9 billion to stand at €950.3 billion, mainly on account of the public sector purchase programme. The average liquidity provided by the public sector purchase programme, the third covered bond purchase programme and the asset-backed securities purchase programme rose by €155.7 billion, €21.1 billion and €3.4 billion respectively. The redemption of bonds held under the securities markets programme and the previous two covered bond purchase programmes amounted to €4.3 billion.

Excess liquidity

As a consequence of the developments detailed above, average excess liquidity rose by €93.3 billion to stand at €693.6 billion in the period under review (see chart). The increase in liquidity was more noticeable in the second maintenance period, when average excess liquidity rose by €44.4 billion on account of increased purchases and slightly smaller increases in autonomous factors compared with the first maintenance period. The relatively small increase during the first maintenance period was mainly driven by the larger rise in autonomous factors, which partially absorbed the increase in the asset purchase programme.

The rise in excess liquidity was mostly reflected in higher average recourse tothe deposit facility, which increased by €59.3 billion to stand at €245 billion in the period under review. Average current account holdings also increased, albeit to a lesser extent, by €34.9 billion, to stand at €562.7 billion.

Interest rate developments

In the review period, money market rates decreased further on the back of the cut in the deposit facility rate to -0.40%. In the unsecured market, the EONIA (euro overnight index average) averaged -0.286%, down from an average of -0.184% in the previous review period. While the EONIA was almost flat in the first maintenance period, the cut in the deposit facility rate by an additional 0.10%, with effect from the start of the second maintenance period, led to a 0.101 percentage-point decline in the EONIA. In the context of the continued increase in excess liquidity, the pass-through of the negative rates was almost immediate. Furthermore, secured overnight rates declined in line with the deposit facility rate to levels closer to the deposit facility rate. Average overnight repo rates in the GC Pooling market^[11] declined to -0.332% and -0.321% for the standard and extended collateral baskets respectively, down 0.088 percentage point and 0.083 percentage point compared with the previous review period.

Box 3 Low interest rates and households’ net interest income

The ECB’s accommodative monetary policy stance has substantially lowered borrowing costs for firms and households, while also lowering the returns on savings. As households do not only borrow, but also save, this raises the question about the extent to which lower interest rates have affected households’ net interest income. This is particularly relevant when assessing the impact of lower interest rates on aggregate consumption.

Households’ interest earnings have decreased by 3.2 percentage points as a share of disposable income since autumn 2008. Chart A shows the evolution of household income from holding interest-bearing assets such as deposits, bonds and loans.^[12] However, this excludes the effect of lower interest rates on households’ income and wealth via the investments of pension funds and life insurance providers, and the capital gains on long-term bonds and equities.

While interest earnings have declined, interest payments have also decreased considerably. Between the third quarter of 2008 and the fourth quarter of 2015 interest payments fell by about 3 percentage points relative to disposable income. The drop in interest earnings is comparable to the drop in interest payments, meaning that the average euro area household’s net interest income has been largely unaffected. At the same time, to the extent that individual households are net savers or net borrowers, in terms of net interest income some households have gained from lower interest rates while others have lost.

The net interest income of the household sector has remained fairly stable in Germany and France, but less so in Italy and Spain. Chart B shows that, in Germany and France, the drop in interest earnings and payments is comparable, meaning that lower interest rates have had a minimal effect on the net interest income of the household sector as a whole. Conversely, in Italy, the drop in household interest earnings is more than twice as large as the drop in household interest payments, with a negative impact on households’ overall net interest income. The reason for this is that Italian households hold a relatively large amount of interest-bearing assets (see Chart C), whereas they are relatively less indebted (see Chart D). In Spain, the drop in interest payments is significantly larger than the fall in interest earnings, with a positive impact on households’ overall net interest income. The larger decline in interest payments in Spain is explained by both the high stock of household debt (Chart D) and the fact that the interest rates paid on a large share of mortgages are indexed to money market rates. The stronger impact on interest payments in Spain is also in line with evidence that monetary policy has relatively large effects in countries with adjustable-rate mortgages.^[13]

Despite lower interest earnings for net savers, low interest rates continue to support private consumption. Lower interest rates typically support consumption today through intertemporal substitution for future consumption, as borrowing becomes cheaper and saving becomes less rewarding. In addition, as average euro area household net interest income has been largely unaffected, lower interest rates have mainly redistributed resources from net savers to net borrowers. As net borrowers typically have a higher marginal propensity to consume than net savers, this redistribution channel of lower interest rates further supports aggregate consumption.^[14]

Lower interest rates also support the wealth and income of households through other channels. Households tend not only to be savers; they also invest in other assets for which they do not necessarily receive interest payments. There is evidence that the positive impact of lower interest rates on the prices of euro area stocks and bonds has been significant.^[15] Moreover, lower borrowing costs have not only stimulated investment and consumption; they have also supported households’ income through higher employment. By holding interest rates low, the ECB has encouraged the demand that is needed to bring the economy back to potential, so that, ultimately, interest rates can rise again.

Box 4 Improved timeliness of the euro area quarterly GDP flash estimate: first experiences

On 29 April 2016, Eurostat published for the first time a preliminary flash estimate for euro area and EU GDP with timeliness of 30 days after the end of the reference quarter (first quarter of 2016). This new development meets a long-standing request from users for more timely information about economic growth in Europe. It aims at establishing a release calendar of 30, 60 and 90 days after the end of the reference quarter for national accounts statistics. Moreover, it aims to fulfil the commitment made by the European Statistical System (ESS) to provide policymakers with reliable, comparable and timely statistics.^[16] The GDP flash estimate released 45 days after the end of the reference quarter (published since May 2003) has been considered to be an intermediary step towards that aim.^[17] This flash estimate is used to analyse the conjunctural developments in the euro area and provides important input for the ECB's economic analysis, macroeconomic projections and short-term forecasting. It will continue to be published by Eurostat in parallel until the new preliminary GDP flash estimate is better established and more countries start publishing their national preliminary flash estimates. Neither flash estimate, however, provides information on revisions to the previous quarters' results, although revisions to the preliminary GDP flash estimate can be observed with each subsequent release.

The underlying methodology for the preliminary GDP flash estimate for the euro area (and the EU) is the same as that applied for compiling the GDP flash estimate at 45 days.^[18]The quarter-on-quarter growth rate of euro area GDP is estimated from national data by aggregating the national seasonally and calendar adjusted quarter-on-quarter growth rates using the annual weights of country GDP in current prices for the previous year. The euro area GDP is then derived by applying the estimated euro area growth rate for the current quarter to the level of GDP for the previous quarter, thus also allowing the year-on-year GDP growth rate to be compiled. The main difference with regard to the GDP flash estimate at 45 days is in the availability of national data to users. Most euro area countries do not yet publish the GDP flash estimates at 30 days but provide them to Eurostat on a confidential basis as input for compiling the euro area and EU preliminary GDP flash estimates. At present only six euro area countries: Belgium, Spain, France, Latvia, Lithuania and Austria (representing 39% of euro area GDP in 2015) publish GDP flash estimates at 30 days. The euro area GDP preliminary flash estimate for the first quarter of 2016 was based on 11 euro area countries and covered 94% of total euro area GDP, of which 55% was provided on a confidential basis.^[19] The table below provides an overview of the national GDP release practices, as well as the extent of compliance with the ESA 2010 legal requirement to provide data at 60 days after the end of the reference quarter. This overview suggests that there are some trade-offs in terms of timeliness, level of detail and quality for compiling quarterly national accounts which need to be considered when analysing the data.

The main difficulty in the national estimation of GDP flash estimates at 30 days arises from the limited availability of source data for the third month of the quarter; the coverage of the source data used in compiling the national GDP of the subsequent estimates improves significantly. For the national preliminary GDP flash estimates, the third month is usually estimated or partially estimated by applying statistical modelling techniques that make use of available monthly information (e.g. short-term statistics, business surveys, price statistics and preliminary estimates of the source data). Several estimation methods are applied at the national level for the GDP flash estimate: direct approaches (e.g. autoregressive distributed lags, dynamic factor models), indirect approaches (temporal disaggregation techniques), pure forecasting models (autoregressive integrated moving average (ARIMA) models, structural time-series models) or multivariate models (vector autoregression (VAR), structural models). The choice depends on the national source data availability for the third month – at about 28 days – after the end of the reference quarter while, at the same time, applying the same compilation practices as in the regular quarterly national accounts (i.e. non-flash estimates) to ensure closeness or a high level of consistency with the final results.

While it is still too early to assess the reliability of the newly available euro area preliminary GDP flash estimate, according to Eurostat's tests^[20] it has met predefined recommended quality acceptance criteria. They showed the following results for the euro area preliminary GDP flash estimate^[21]:

• Unbiased estimate of the euro area GDP growth at 45 days with an average revision within +/-0.05 percentage point and no more than 66.7% of revision in the same direction. Against this criterion, the results for the euro area were 0.0 percentage point of average revision and equal distribution of the upward and downward revisions, accordingly.
• Maximum average absolute revision for the euro area of 0.1 percentage point in comparison to the flash GDP growth at 45 days and 0.13 percentage point in comparison to the GDP growth published around 65 days after the end of the reference quarter. The actual results for the euro area were in both cases 0.06 percentage point.
• Sufficient coverage defined as 70% of total GDP for the euro area. For the quarters used for the test estimates, the coverage was on average 83% of total GDP for the euro area, consistently reaching 94% in the last three quarters.

When examining the data for the first quarter of 2016, the preliminary GDP flash estimate for the euro area indicated quarter-on-quarter growth of 0.55%, which was revised down by 0.03 percentage point to 0.52% with the release of the GDP flash estimate at 45 days. This could be attributed to two main factors: first, revisions attributable to better national source information and, second, a marginally larger coverage of the euro area (97% of the euro area GDP).

The improved timeliness of the estimates of quarterly GDP growth for the euro area from 45 to 30 days after the end of the reference quarter is an important step for policymakers. Various processes serving monetary policy preparation, such as macroeconomic projections and analytical assessments will benefit. The earlier availability of information on GDP developments in the euro area and euro area countries will enable a more thorough analysis of the implications of these developments for the near-term outlook.

Box 5 Country-specific recommendations for fiscal policies under the 2016 European Semester

On 18 May 2016 the European Commission announced its proposed country-specific recommendations for economic and fiscal policies for all EU Member States except Greece, including recommendations for implementing the EU’s Stability and Growth Pact (SGP). The country-specific recommendations are scheduled to be approved by economic and finance ministers on 17 June and to be endorsed thereafter by the European Council on 28-29 June.^[22] The Council’s fiscal policy recommendations aim to ensure that countries comply with the SGP. Hence, they give opinions on the 2016 updates to stability and convergence programmes, which governments had to submit to the European Commission and the Council by mid-April. In terms of follow-up, the country-specific recommendations for fiscal policies issued under the 2016 European Semester will need to be reflected in the draft budgetary plans for 2017 which euro area countries have to submit to the Eurogroup and the European Commission by mid-October. Against this background, this box reviews the recommendations for fiscal policies that were addressed to the 18 non-programme euro area countries.

According to the European Commission’s spring 2016 forecast, the aggregate fiscal stance of the euro area is expected to be slightly expansionary in 2016 and 2017.^[23] On the one hand, this indicates that euro area countries which have achieved their medium-term budgetary objective (MTO), most notably Germany, are using part of their fiscal space. On the other hand, it also reflects the fact that a sizeable number of countries, including those with high government debt levels, are falling short of their structural consolidation commitments under the Pact (see the table).

Consequently, the Commission’s country-specific recommendations identify risks of non-compliance with the structural consolidation requirements of the SGP in many euro area countries. According to the European Commission’s spring 2016 forecast, none of the countries with a deficit above the 3% of GDP reference value in 2015 (i.e. Portugal, Spain and France) is expected to deliver a structural consolidation over the period 2016-17 (i.e. a reduction of the budget deficit through factors other than the impact of the economic cycle and temporary budgetary measures). Moreover, significant shortcomings vis-à-vis structural adjustment requirements are anticipated in countries that are currently under the Pact’s preventive arm, even though for some countries these requirements have been lowered markedly. In concrete terms, following a recent agreement on how to operationalise the flexibility that the SGP includes for structural reforms^[24], countries that have not achieved their MTOs can progress towards them more slowly by delivering smaller structural consolidation efforts if they implement structural reforms, additional investment and pension reforms.^[25] The structural adjustment requirements have for some countries been further reduced to accommodate the costs they incur for hosting refugees and for additional security spending. Overall, the granting of this flexibility has lowered the requirements for progressing towards the MTO from, on average, 0.5% of GDP to -0.1% of GDP in 2016.^[26] This notwithstanding, the countries under the SGP’s preventive arm which have not yet achieved their MTO are expected to fall short of the reduced requirements by conducting expansionary fiscal policies corresponding, on average, to -0.3% of GDP. This further delays the achievement of MTOs by Member States and thus hinders a return to robust public finances during the unique window of opportunity provided by favourable financial conditions.^[27]

The fiscal policy recommendations for countries therefore vary according to the existing room for budgetary manoeuvre. They call on Member States whose structural efforts are expected to fall short of their commitments under the SGP to implement further measures to ensure the required compliance. Furthermore, countries that have not yet achieved their MTOs and are expected to maintain general government debt at a level that exceeds the 60% of GDP threshold (Belgium, France, Spain, Italy, Ireland, Portugal and Finland) are recommended to use any so-called windfall gains, i.e. savings from lower than anticipated interest payments, for deficit reductions. At the same time, among the euro area countries that have already reached their MTOs, Germany is recommended to achieve a sustained upward trend in public investment, especially in infrastructure, education, research and innovation. The Netherlands are recommended to prioritise public expenditure towards supporting more investment in research and development.

On 18 May the European Commission also released recommendations regarding the implementation of the Stability and Growth Pact. The Commission recommended abrogating the excessive deficit procedures (EDPs) for Ireland and Slovenia by their 2015 deadlines as well as the abrogation of the EDP for Cyprus one year ahead of its 2016 EDP deadline. In reports prepared under Article 126(3) of the Treaty on the Functioning of the European Union (TFEU), the Commission examined the breach of the debt criterion in Belgium, Italy and Finland in 2015 and decided against opening an EDP. In the case of Finland, the breach of the government debt reference value by 3.1% of GDP is explained by mitigating factors, including financial support to other euro area countries to safeguard financial stability and also the negative impact of the economic cycle. As regards Belgium and Italy, the Commission reports accounted for relevant factors, including (i) compliance with the structural effort requirements under the preventive arm of the SGP, (ii) unfavourable economic conditions (i.e. weak growth and low inflation) which make compliance with the debt rule more difficult, and (iii) implementation of growth-enhancing structural reforms. For both countries, the assessment of compliance with the SGP’s preventive arm over 2016-17 took account of reduced requirements resulting from the flexibility granted to cope with the costs of hosting refugees and additional security spending. Moreover, in the case of Italy, additional flexibility was granted for structural reforms and investment which – on top of the above-mentioned flexibility – reduced the structural effort requirement in 2016 from 0.5% of GDP to -0.35% of GDP, in the light also of the authorities’ commitment to broad compliance with the SGP in 2017. In the autumn the Commission will revisit the resumption of the adjustment path towards the MTO, based on the draft budgetary plan for next year. The assessments of compliance with the debt rule did not consider previous shortfalls in fiscal consolidation as an aggravating factor or quantify the impact of relevant factors in a comprehensive manner to ensure that any discrepancies with the debt rule were explained in full.^[28]

Furthermore, the European Commission’s country-specific recommendations advised extending the EDP deadlines for Portugal and Spain by one year to 2016 and 2017, respectively, with structural effort requirements of 0.25% of GDP this year. Notably, while the country-specific recommendations are based on Articles 121 and 148 TFEU, the Council has to take decisions under the excessive deficit procedure as laid out under Article 126 TFEU. Moreover, while Article 10(3) of Council Regulation (EC) No 1467/97^[29] asks the Council to act immediately in the event that an excessive deficit has not been corrected, the assessment of whether the deadline extensions should be associated with a stepping up of the EDP and possible sanctions was postponed to early July. Apart from this, the recommended structural effort of 0.25% of GDP compares with an adjustment of “at least 0.5% of GDP” envisaged in Article 3(4) of Regulation No 1467/97.

Finally, the Commission did not recommend opening a significant deviation procedure for Malta, which under the SGP’s preventive arm was found to have deviated significantly from both the structural effort requirement and the expenditure benchmark in 2015 under the Commission’s spring 2016 forecast.

To ensure credibility, it is important that the governance framework is applied in a legally sound, transparent and consistent manner across time and countries. Learning the lessons from the crisis, major improvements were made to the EU’s fiscal governance framework in 2011 and 2013. The introduction of the debt rule to the corrective arm of the SGP and the establishment of the significant deviation procedure for the preventive arm (to help ensure sufficient progress towards the MTOs) are of particular significance here. The same holds for changes to the decision-making process intended to shield the European Commission from political pressure with the aim of increasing automaticity in the application of rules and sanctions. For these improvements to be effective, the full, transparent and consistent implementation of the SGP is essential. The approach to the implementation of the SGP under the 2016 European Semester has raised a number of questions, which will need to be examined.

Articles

The role of euro area non-monetary financial institutions in financial intermediation

With bank lending staging a slow and protracted recovery in the wake of the global financial crisis, non-monetary financial institutions (non-MFIs) have expanded their share of financial intermediation in the euro area. In doing so, they have helped to mitigate the effects of the financial and sovereign debt crises on the euro area economy. At the same time, the observed shift in intermediation towards institutions other than banks may have implications for monetary policy transmission. Differences in regulation and supervision, in particular, appear to motivate some non-MFIs to adjust their risk exposures more quickly than banks in response to changes in the business and financial cycles, thereby accelerating the transmission of monetary policy, while other sectors, like long-term institutional investors, may have a stabilising impact. In this respect, the rising role of non-MFIs that are subject to less regulation and supervision has to be assessed for its possible repercussions on monetary policy transmission. In addition, the interplay of all financial intermediaries needs to be monitored from a monetary policy perspective.

Introduction

With lending by monetary financial institutions (MFIs) recovering only slowly, financial institutions outside the MFI sector have accounted for a rising share of financial intermediation in the euro area since the global financial crisis.^[30] Between the end of 2008 and the fourth quarter of 2015, non-MFIs expanded their share of financial assets held by euro area financial corporations from 42% to 57%.^[31] They have thus helped channel funding to the various sectors of an economy whose financial intermediation has traditionally mainly relied on banks.^[32]

The interaction of several factors, both cyclical and structural in nature, can be identified as being among the key drivers of this shift. On the side of euro area banks, lending has languished as they have dealt with the fallout from the global financial crisis and the euro area sovereign debt crisis. This reduced supply of finance from banks is one cause of the rise of intermediation by non-MFIs. At the same time, the rise of non-MFIs has been supported by the low level of interest rates in the wake of the financial crisis, as well as longer-term structural factors, including demographic trends and population ageing. These have led to an increase in purchases of products offered by insurance corporations and pension funds (ICPFs) and to higher investment flows into non-money market fund investment funds (non-MMF IFs), as returns on existing pension schemes have lagged behind objectives. In addition, regulatory arbitrage may have transferred some intermediation activities from banks to non-MFI sectors.

Structural change in euro area financial intermediation, such as the shift from MFIs to non-MFIs, has implications for monetary policy transmission. Most of the transmission channels of monetary policy work by influencing the way in which financial intermediaries provide funding to the economy. In this setting, banks retain a major role in the euro area. However, the growing importance of non-MFIs makes them increasingly relevant for the propagation of monetary impulses. In this role, non-MFIs may react differently from banks to changes in the monetary policy stance, thereby altering the way monetary policy is transmitted through financial markets and intermediaries' balance sheets to the real economy.

In particular, some non-MFIs may accelerate the transmission of monetary policy. Specifically entities in the other financial institution (OFI) sector may react faster than banks to monetary policy impulses and changes in the economic and financial outlook. This means that they also retrench more rapidly in times of crisis. Part of this is associated with the less stringent regulation and supervision some non-MFIs are subject to. By contrast, banks as deposit-taking institutions hold reserves with central banks and act as their direct counterparties in monetary policy operations. For this reason they also generally enjoy a public sector backstop associated with extensive regulation and supervision.

Consequently, understanding trends and developments in the euro area non-MFI sectors is crucial for monetary policy. Against this background, Section 2 of this article provides a brief overview of academic findings on the role of the non-MFI sectors in monetary policy transmission. Section 3 describes and analyses the role of non-MFIs within the financial system of the euro area, while Section 4 focuses on the trends observed for the individual constituents of the euro area non-MFIs. Sections 3 and 4 both provide examples of developments that have implications for monetary policy transmission stemming from the findings presented in Section 2. Section 5 concludes.

The role of non-MFIs in monetary policy transmission – a review of the literature

Monetary policy affects the economy through several sectors and channels of transmission. Most of these channels work by influencing the decisions of financial intermediaries, which provide funding and investment opportunities to financial and non-financial sectors of the economy. In the euro area, MFIs, which comprise banks and money market funds (MMFs), are the main providers of financial services in the economy and therefore play a major role in the transmission of monetary policy. However, owing to their increasing relevance in the financial sector, non-MFIs have now also become more important for the transmission of monetary policy impulses. Non-MFIs include non-MMF IFs, other financial intermediaries except ICPFs (including financial vehicle corporations, FVCs), financial auxiliaries, captive financial institutions and money lenders, and ICPFs (see Box 1 for a detailed description of non-MFIs according to the European System of Accounts 2010).

Owing to differences in business models and associated legal and regulatory requirements, non-MFIs respond differently from banks to monetary policy impulses. Banks, as deposit taking institutions, are typically highly regulated financial intermediaries subject to capital and liquidity requirements. Together with money market funds (seen as providing close substitutes for deposits) and central banks they comprise the MFI sector, as the creator of inside and outside money respectively. The MFI sector has thus traditionally been seen as the natural starting point for analysing monetary transmission in bank-based financial systems. At the same time, banks, as depository institutions subject to minimum reserve requirements have, in times of stress, access to emergency liquidity assistance from central banks and, if they become insolvent, they are subject to an orderly resolution process that can involve public backstops. Non-MFIs are financial intermediaries that can also be involved in maturity and liquidity transformation and credit risk transfer, but they generally do not have access to public backstops or central bank liquidity.

The mechanisms through which monetary policy is transmitted have been the focus of extensive analysis and empirical investigation over the last few decades. The main focus of this effort, especially in the early years, has been on the role of the assets and liabilities of banks, which provided the primary source of debt financing for the non-financial corporate (NFC) sector and for households in the euro area. However, some of the mechanisms featured in this research can also provide insight into the processes involving non-MFI sectors to different degrees.

Broadly speaking, the channels of monetary transmission comprise an interest rate (or cost-of-capital) channel, a broad credit channel and a risk-taking channel.^[33] While these three channels can potentially work for MFIs and non-MFIs alike, there may be differences in terms of speed and amplitude in the transmission of monetary policy impulses. This is due, for example, to the possible interactions with the different regulatory and supervisory frameworks in which financial intermediaries operate. In particular, the presence of less regulated – and therefore more flexible – non-bank intermediaries can make monetary transmission faster.^[34]This is because they can adapt their risk exposure to changes in financing conditions more quickly.^[35]

In particular, some non-MFIs seem to respond faster to changes in the business and financial cycles than banks. Indeed, some studies have shown that the leverage of security brokers and dealers is pro-cyclical and linked to monetary policy changes. Tighter monetary policy tends to lower the risk-taking of broker-dealers, leading to an increase in the pricing of risk.^[36] Concerning other intermediaries, some studies have shown that ICPFs, as long-term investors, are in principle better placed to look through short-term market volatility and play a counter-cyclical role.^[37] At the same time, such institutional investors strongly depend on stable returns from fixed income and have been shown to react relatively strongly to interest rate changes. For example, insurance corporations, which are large holders of securities, tend to engage in a search for yield, as they systematically choose riskier investments from among the assets fulfilling their regulatory requirements.^[38] This seems to be intensified when interest rates are low. In parallel, however, their long investment horizons increase their resilience to sudden changes in monetary policy rates. When looking at investment funds, the available evidence generally supports the notion that lower real interest rates shift portfolio investment towards riskier assets – out of the money market and into the riskier equity market – causing significant increases in stock prices in countries where investment home bias is strong.^[39]

Overall, existing research suggests that the increasing role of non-MFIs in the financial sector may imply a somewhat faster transmission of monetary shocks, notably through the risk-taking channel. At the same time, recent historical analysis has shown that the relationship between credit and broad money began to decouple after the early 1970s, when financial intermediaries other than banks started to become important contributors to credit intermediation in a number of countries, but to a lesser extent in the euro area.^[40] In line with this, it is found that non-MFIs induce higher time-variation in the velocity of money and credit, implying potentially greater instability in the transmission of monetary policy.^[41] More generally, the growing role of non-MFIs affects the relative importance of different transmission channels of monetary policy.

The role of non-MFIs within the euro area financial system

In the years preceding the crisis, both bank and non-bank financial intermediaries boosted risk taking and credit growth and facilitated a rapid expansion of the financial sector (see Chart 1). Financial intermediaries exploited securitisation as a means of managing their balance sheets more flexibly and thereby increased overall credit supply. At the same time, (risky) illiquid loans were transformed into short-term, money-like marketable instruments, which were perceived to be almost risk-free and were held by banks or sold on to households, firms and institutional investors. The outbreak of the sub-prime crisis in the United States in 2007 revealed that these developments were unsustainable. In the years that followed, the collapse of securitisation via non-MFI conduits, often sponsored by banks, contributed, among other factors, to the sharp contraction in the flow of bank credit. Banks were no longer able to transfer risk off their balance sheets, a process that had facilitated further loan origination, or even had to bring risks that had been moved off their books back onto their balance sheets. This experience illustrates the capacity of accounting and regulatory changes to blur the line between bank and non-bank lending, boosting the risk-taking channel and altering the transmission of monetary policy.^[45]

The size of the euro area financial sector has continued to increase since the global financial crisis, but at a slower pace and with diverging developments across MFIs and non-MFIs. Between the end of 2008 and the end of 2015, financial assets held by euro area financial corporations increased from €51 trillion (528% of GDP) to €64 trillion (613% of GDP). The share of these assets held by MFIs fell from 58% to 43% over this period. By contrast, the share held by non-MFIs rose from 42% to 57%. Of this, non-MFIs other than ICPFs accounted for a 42% share (up 11.8 percentage points when compared with the end of 2008), with ICPFs accounting for 15% (up 2.7 percentage points).

Banks have experienced a slowdown in balance sheet growth or a shedding of assets as a result of the global financial crisis and the euro area sovereign debt crisis and associated regulatory changes. In particular, on the credit supply side, the fragile economic environment triggered a surge in non-performing loans and a marked deterioration in the balance sheets of banks. At the same time, stricter regulation and supervision, coupled with feeble growth and low interest rates, have challenged the existing business models of banks, forcing them to adapt. However, the ECB's non-standard measures have provided liquidity and supported credit, mitigating the risks of disorderly deleveraging in the banking sector as a whole. On the credit demand side, economic weakness and depressed asset prices lowered the collateral value underpinning loans to the non-financial private sector. Together, this resulted in a net tightening of credit standards and a restriction of bank credit to NFCs and households in 2008 and 2009, and again in 2011 and 2012.

While the net flow of finance from MFIs to NFCs contracted in 2009 and 2010, and again between 2012 and 2014, the flow of finance from non-MFIs remained positive (see Chart 2). Over this period, the primary form of financing offered by non-MFIs took the form of market and non-market-based equity financing, the issuance of debt securities and the provision of loans. The sustained provision of funding from non-MFIs after the crisis hit was supported by a range of factors and has had a stabilising impact on the euro area economy.^[46]

• First, very low interest rates and the associated search for yield by investors have supported financial intermediation by non-MFIs.Specifically, the activities of non-MFIs were helped by factors impacting the portfolio choices on the asset side of the non-financial sectors, such as lower returns on bank deposits, falling risk premia and a recovery in a range of asset markets. On the liability side, progress on repairing balance sheets allowed firms in the euro area to tap financing sources other than bank credit, such as equity and corporate debt issuance. Insofar as these developments were related to the low interest rates resulting from the ECB's monetary policy, they provide another illustration of the mechanics of the risk-taking channel for monetary policy transmission.
• Second, structural factors, such as demographic trends, have also benefited financial intermediation by non-MFIs. Population ageing has led to a rise in purchases of life insurance and pension investment products, partly reflecting households' increased concerns about the sustainability of both public and private pension schemes in view of lower potential growth, high sovereign debt levels and low returns on existing pension schemes.
• Third, some non-MFIs have been less exposed to regulatory tightening than banks, opening opportunities for regulatory arbitrage. However, large parts of the non-MFI sector in the euro area, such as ICPFs, are in fact subject to extensive regulation and supervision. As a result, regulatory arbitrage is likely to have played at best a secondary role in the observed shift of financial asset holdings from banks to non-MFIs in these cases.
• Fourth, the rising share of non-MFIs in the euro area financial sector also reflects methodological changes. The transition to the ESA 2010 implied the assimilation of a large set of entities, such as financing SPEs, into the group of non-MFIs, having previously been classified in the NFC sector alongside the firms they are typically serving. In fact, the rapid expansion of financing SPEs explains some 15% of the overall increase in the size of the financial sector between the end of 2008 and the end of 2015.

Data improvements over time will make it possible to isolate and analyse in greater detail financial flows across sectors. In future, a more conclusive assessment might be feasible once longer time series of new data providing a "who-to-whom" breakdown of marketable instruments become available. The ECB began publishing such data in April 2016 (see Box 2). These statistics may be used, for instance, to conduct detailed analyses of the role of various institutional sectors in providing direct and indirect financing to the different parts of the economy. Together with macroeconomic, financial market and confidence indicators, these data can also provide a better insight into the portfolio investment behaviour of different economic sectors.

The role of various non-MFI sectors in the euro area

Other OFIs constitute the largest group of non-MFIs. This is a residual group comprising a very heterogeneous set of institutions.^[49] Together this group holds a 41% share in the total financial assets of non-MFIs (see Chart 3). Non-MMF IFs and insurance corporations (ICs) account for 28% and 19% respectively, while FVCs and pension funds (PFs) play a significantly smaller role.

Half of the increase in the size of the financial sector between the end of 2008 and the end of 2015 can be attributed to actual transactions by OFIs (see Chart 4). Most of the other half was due to revaluation effects associated with the recovery and the subsequent sharp increase in stock and bond prices. Within OFIs, 40% of the net accumulation of financial assets was concentrated in non-MMF IFs, with other OFIs accounting for the remainder.

Non-money market fund investment funds (non-MMF IFs)

Non-MMF IFs account for an increasing share – currently 28% – of the total financial assets held by euro area non-MFIs (see Chart 3). They thus play a significant and increasing role in providing market-based financing to euro area banks and NFCs.^[50] The assets of non-MMF IFs are primarily concentrated in debt securities and equity holdings (see Chart 5). Non-MMF IFs hold around 13% and 9% of the debt securities issued by euro area NFCs and banks respectively (see Chart 6). Moreover, non-MMF IFs also hold around 14% of the quoted shares issued by these two sectors. Importantly, however, 40% of their debt security holdings and 60% of their shares and other equity holdings consist of securities issued by the rest of the world. This may reflect both an investor preference for holding globally diversified portfolios and the small size of euro area stock and bond markets relative to global securities markets.

Possible reasons for the increased role of the non-MMF IF sector since the global financial crisis include the low interest rate environment and demographic dynamics. In particular, low deposit rates have enhanced the attractiveness of investing in securities, thereby benefiting the business of non-MMF IFs. Similarly, monetary policy measures have facilitated a reduction in risk premia, a rise in investor confidence and a decrease in investor risk aversion, all of which support stronger inflows into non-MMF IFs. This would seem to be in line with the mechanics of the risk-taking channel of monetary policy transmission that was discussed in Section 2. Finally, non-MMF IFs have profited from concerns among euro area households about their future pension benefits. Such concerns have led to higher savings which, in the face of low interest rates, have been channelled towards riskier assets to achieve the level of return that enables households to accomplish the desired degree of lifetime consumption smoothing.

Since the peak of the global financial crisis at the end of 2008, non-MMF IFs' holdings of equity securities have risen more than their holdings of debt securities (see Chart 5). Valuation effects, specifically the sharp recovery in stock prices since the lows seen after the collapse of Lehman Brothers, are the main explanation for the strong increase in equity holdings. In fact, net purchases of debt securities by non-MMF IFs have been considerably larger than net purchases of equities (see Chart 7).

Moreover, non-MMF IFs have tended to favour foreign investments (see Chart 7), possibly in relation to some waning of euro area investors' home bias during the peak of the sovereign debt crisis. They have also modestly scaled back their exposure towards the euro area banking sector. To some extent, this can be explained by the declining financing needs of euro area banks owing to their deleveraging efforts and their ability to obtain funding through customer deposits and central bank facilities.

Financial vehicle corporations (FVCs)

The financial asset holdings of FVCs have fallen steadily since the global financial crisis, reflecting the decline in securitisation transactions that previously allowed banks to shift risk off their balance sheets (see Chart 8).^[51] Primarily involved in the securitisation of loans to households, FVCs hold 12% of the total loan claims on euro area households. For loan claims on euro area NFCs, the share of FVCs is smaller at 3%.^[52]

Possible drivers of the decline of FVCs include deleveraging pressures and the stigma attached to these instruments in the wake of the global financial crisis. As banks and the non-financial private sector consolidated their balance sheets, the credit growth necessary to sustain the continued securitisation of loans evaporated. At the same time, the prominent role of FVCs in the financial market turmoil of 2008 and 2009, regulatory developments and other structural factors triggered a decline in securitised products, irrespective of the potential of simpler, more transparent and more robust securitisation to enhance financial intermediation.^[53]

Other OFIs

Among non-MFIs in the euro area, financial assets of other OFIs have grown significantly in recent years, accounting for 41% of the total, with about a quarter of this share attributable to financing SPEs.^[54]In order to benefit from a favourable tax regime and financial technology, financing SPEs – which are subsidiaries of another company – are typically located in a country, within or outside the euro area, which is different from the domicile of their parent.^[55] Bond market financing obtained by financing SPEs and returned to their parent in the form of loans account for close to one-third of the increase in total financial assets held by other OFIs since the global financial crisis.

Other OFIs mainly hold equity and loan claims on their asset side (see Chart 9). This is due to the fact that the other OFI sector is generally dominated by highly specialised business models. Venture capital corporations, development capital companies and holding companies provide risk capital to firms, whereas financial leasing companies and financing SPEs provide loans.

As more granular data on other OFIs are scarce and the category encompasses a very heterogeneous set of entities, comprehensive analysis is challenging. However, it is likely that reductions in risk aversion and improvements in investor confidence since the global financial crisis have bolstered the business of at least some other OFIs, such as venture capital corporations, as was highlighted in Section 2. In addition, in the same way that tax arbitrage is one of the motives for the establishment of financing SPEs, regulatory arbitrage might be one of the factors shaping trends in the other OFI sector, although firm evidence of this is not easily available.

Insurance corporations and pension funds (ICPFs)

The financial assets of ICPFs account for 25% of total assets held by euro area non-MFIs. The portfolios of ICPFs are primarily invested in debt securities, particularly of governments, and equities (see Charts 10 and 11). This reflects their attempts to match their assets with their liabilities, which mostly consist of life insurance and pension claims with a long residual maturity. The preference of ICPFs for government bonds is largely due to their institutional asset allocation policies and the relatively small size of the euro area corporate bond market.

ICPFs are also an important source of funding for the private sector. They hold 19% and 15% of the debt securities issued by euro area NFCs and banks, respectively, in addition to around 3% of the quoted shares issued by these sectors. At the same time, ICPFs hold 20% of the debt securities issued by euro area sovereigns. By contrast, loans by ICPFs to households and NFCs in the euro area are relatively marginal, accounting for a mere 3% and 1%, respectively, of the total loan claims against these borrowers.^[56] However, in some euro area countries insurance corporations have started to compete with banks in the household mortgage market, as new legislation and technological innovation have enabled the provision of loans via specialised internet platforms.

After declining modestly in the immediate aftermath of the global financial crisis, the financial assets of ICPFs have significantly expanded in recent years. The drivers of this development are likely to be similar to those mentioned in the case of non-MMF IFs and include factors related to population ageing and the positive effects of an accommodative monetary policy on confidence, risk taking and the prices of securities. In this environment, ICPFs have increased their risk exposure – within the limits posed by statutory requirements – by investing in equities and the shares/units of non-MMF IFs rather than in debt securities (see Chart 12). In fact, annual flows from ICPFs into these instruments in 2014 and 2015 reached levels similar to those observed in 1999 and 2000. Again, this exemplifies the functioning of the monetary policy transmission channels described in Section 2.

A look at the period before the global financial crisis provides further evidence that the portfolio choices of ICPFs respond to financial cycles.^[57] In particular, between 2003 and 2008, ICPFs increased their debt securities holdings significantly more than their exposure to equities, in spite of favourable stock markets and a flattening of the yield curve (see Chart 12). This behaviour reflected a change in risk appetite among ICPFs after the losses incurred in the wake of the bursting of the dotcom bubble in 2000 forced them to repair their balance sheets. In addition, the response of ICPFs to a variety of regulatory, valuation and accounting changes also played a role.^[58]

Concluding remarks

With euro area banks cutting back the supply of credit in the wake of the global financial and the euro area sovereign debt crises, the role played by the non-MFI sectors in financial intermediation has increased and has helped to mitigate the effects of the crises on the euro area economy. This trend was facilitated by very low interest rates leading to a search for yield by investors, structural factors, such as an ageing population in the euro area, and some scope for regulatory arbitrage. In this environment, non-MMF IFs and ICPFs have been particularly prominent in increasing their role in euro area financial intermediation in recent years. As large holders of debt securities and equity, these entities have provided a significant amount of financing to the real economy, although not exclusively to the benefit of the euro area, as they are generally holders of globally diversified portfolios. Among other OFIs, venture capital corporations are likely to have profited from a search for yield, while the activities of financing SPEs are often related to tax arbitrage by sponsoring corporations.

These developments have implications for monetary policy transmission. As Section 2 has shown, the channels of monetary policy transmission to the real economy apply – in different forms – to MFIs and non-MFIs alike. However, differences in the business models between these two groups of euro area financial intermediaries, also reflected in terms of regulation and supervision, imply that the generally larger role for non-MFIs may speed up the – indirect – transmission of monetary policy.

The increased role of non-MFIs calls for a more integrated analysis of the interplay between different financial intermediaries and transmission channels that complement or substitute the traditional bank lending and interest rate channels. As regards individual sectors among non-MFIs, non-MMF IFs and ICPFs may have less significant implications for monetary policy transmission. Like MFIs, they are subject to regulation and supervision, implying that impulses from monetary policy are likely to find their way to the real economy in a manner similar to MFIs, albeit via different channels. By contrast, the same is not necessarily true for the other OFI sector. As some other OFIs are not subject to the same level of scrutiny as banks, they warrant special monitoring, because the financing they provide has the potential to be of a more cyclical nature, with implications for the stability of monetary policy transmission. However, specifically in this corner of the euro area financial system, data are scarce, although longer time series and new statistics, such as the "who-to-whom" data presented in Box 2 of this article, may remedy some of these shortcomings in the future.

The euro area fiscal stance

This article discusses the concept of an appropriate euro area aggregate fiscal stance in the context of the institutional architecture of Economic and Monetary Union (EMU). To this end, it assesses recent initiatives towards a better coordination of national fiscal policies with a view to ensuring an appropriate euro area-wide fiscal stance which balances the objectives of sustainable public finances and macroeconomic stabilisation.

There is widespread agreement that national fiscal policies need to ensure that public debt is sustainable, while automatic stabilisers can operate freely to cushion country-specific shocks. At the same time, in the event of a very severe crisis, such as the deep recession in 2008-09, automatic fiscal stabilisers alone may not be sufficient to absorb the shock, and additional discretionary action may be required, provided this does not endanger medium-term fiscal sustainability. These elements are all embedded in the rules of the Stability and Growth Pact (SGP). However, there are no rules in the SGP for countries that have over-achieved their targets.

There may be circumstances in which the independent conduct of national fiscal policies does not result in an appropriate aggregate euro area fiscal stance. This article reviews the proposals of the Five Presidents’ Report^[59] in this respect, including the setting-up of a European Fiscal Board – which is expected to become operational by September 2016 – to advise the European Commission on an appropriate fiscal stance both at national and European level within the rules of the SGP. In the longer run, the report envisages the creation of a euro area treasury to improve joint decision-making regarding economic and fiscal policies and the setting-up of a euro area macroeconomic stabilisation function.

Introduction

In Economic and Monetary Union, fiscal policies are a national responsibility. In this respect, they need to ensure the sustainability of government debt and cushion country-specific shocks. Sustainable public finances are a prerequisite for ensuring price stability within the euro area. At the same time, in a monetary union, fiscal policy remains a major tool available to national governments to deal with country-specific circumstances. In the absence of a fiscal authority at the centre, national fiscal policies are governed by the EU’s common fiscal framework, the Stability and Growth Pact, which was agreed in 1997 to operationalise the Maastricht Treaty’s budgetary rules.^[60] Within the SGP, national fiscal policies are considered a matter of common concern – they should be coordinated and should not be allowed to impose disproportionate costs on other EMU participants.^[61]

The SGP framework guides Member States towards achieving sound fiscal positions and provides room to cushion normal cyclical fluctuations via automatic stabilisers. Member States set medium-term budgetary objectives (MTOs) which are intended to anchor progress towards sustainable public finances, while allowing budgetary room for manoeuvre. Adjustments required to meet the MTO are defined in structural terms (i.e. net of the impact of the cycle and one-off measures) and therefore generally allow the full operation of automatic stabilisers. These should be sufficient to deal with normal cyclical developments at national level. Under such circumstances, discretionary fine-tuning of the cycle via active fiscal policy measures is typically regarded as not very effective.^[62] At the same time, the SGP does not contain any rules on the conduct of fiscal policy for countries that have over-achieved their minimum requirements. In this regard, it is asymmetric.

The EU’s current fiscal governance framework contains no rules or instruments to directly manage the aggregate euro area fiscal stance, which is a key difference when compared to fiscal federations such as the United States. In fact, in the absence of fiscal policy instruments at the central level, the euro area-wide fiscal stance is merely the sum of individual euro area countries’ fiscal stances. However, in some situations, a more active management of the euro area-wide fiscal policy stance may appear warranted from an aggregate perspective. The SGP does contain provisions permitting countries to provide fiscal stimulus in exceptional circumstances, provided that this does not endanger medium-term fiscal sustainability. At the same time, the SGP does not oblige those countries with fiscal room for manoeuvre to make use of it. There is therefore no guarantee that the coordination of national fiscal policies through the SGP results in an appropriate aggregate euro area fiscal stance. In the light of this, the Five Presidents’ Report, “Completing Europe’s Economic and Monetary Union”, released in mid-2015, highlights the need to reflect on ways to ensure that “the sum of national budget balances leads to an appropriate fiscal stance at the level of the euro area as a whole”.^[63]

The Five Presidents’ Report contemplates, as steps within a comprehensive overhaul of the institutional architecture of EMU, a more active steering of the euro area-wide fiscal stance. In this context, it envisages the setting-up of a euro area treasury to achieve more collective decision-making on fiscal policy. The report also proposes the creation of a central macroeconomic stabilisation function to complement automatic stabilisers at the national level if national budgets become overwhelmed by very large macroeconomic shocks.

When assessing the “appropriateness” of the fiscal stance both at the national and the euro area level, the European Commission will in future be advised by a new European Fiscal Board, which is scheduled to become operational by September 2016. According to the Five Presidents’ Report, the European Fiscal Board “should lead to better compliance with the common fiscal rules, a more informed public debate, and stronger coordination of national fiscal policies”.^[64]

Against this background, this article discusses the concept of an appropriate euro area aggregate fiscal stance in the context of the EU’s institutional framework. To this end, it assesses the recent initiatives towards better coordination of national fiscal policies with a view to ensuring an appropriate euro area-wide fiscal stance which balances the objectives of sustainable public finances and macroeconomic stabilisation.

The article is structured as follows. Section 2 briefly reviews developments in the euro area fiscal stance over the last decade. Section 3 then discusses the concept of an appropriate euro area aggregate fiscal stance. Section 4 reflects on the limits on coordinating the euro area fiscal stance within the current EU fiscal framework. From this analysis, Section 5 derives institutional considerations relating to the work of the envisaged European Fiscal Board as well as a euro area treasury and a euro area fiscal capacity. Section 6 concludes.

Recent developments in the euro area fiscal stance

The fiscal stance aims to capture governments’ discretionary policy actions. Two principal ways of measuring the fiscal stance are used in practice (see Box 1). First, the change in the cyclically adjusted primary balance, which removes the cyclical component and interest payments from the headline budget balance. Second, bottom-up estimates of discretionary policy measures, which sum up the outcomes of policy measures included in national budgets.

As Chart 1 shows, following several years of tightening, the euro area aggregate fiscal stance appears now to have turned mildly expansionary. The chart depicts the fiscal stance for the period 2007-16 as measured by the change in the cyclically adjusted primary budget balance. It shows that the fiscal stance was loosening in 2008-10, reflecting the impact of several stimulus measures, including the European Economic Recovery Plan (EERP), which the Commission launched in November 2008 and which amounted to about 1.5% of GDP for the euro area. This was followed by a tightening euro area aggregate fiscal stance over the period 2011-13, reflecting comprehensive consolidation packages in euro area countries to restore debt sustainability and correct the excessive deficits that had emerged during the sovereign debt crisis. In 2014 the fiscal stance was broadly neutral in the absence of broad-based fiscal adjustment measures in most euro area countries. According to the European Commission’s 2016 winter forecast, the euro area aggregate fiscal stance is expected to be mildly expansionary in 2015-16.

What is an appropriate euro area fiscal stance?

The fiscal stance and the trade-off between sustainability and stabilisation

Discretionary fiscal policies are generally considered a weak macroeconomic stabilisation tool during normal economic cycles. First, it takes time to adopt and implement a fiscal measure, especially major new programmes (“implementation lag”). Second, fiscal measures in support of the economy tend to be difficult to reverse once implemented, facing resistance from benefiting groups. Third, it is difficult to get the size, timing and economic mechanism of a fiscal impulse measure exactly right.Consequently, there is, for example, a risk that the economic impact of a discretionary fiscal stimulus will start to be felt only once the economy is already picking up, rendering the instrument pro-cyclical rather than counter-cyclical.^[70]

There is therefore broad consensus that automatic fiscal stabilisers represent “the first line of defence” by being a predictable and systematic response to normal asymmetric shocks.^[71]In particular, during a downturn, without the government taking any action, unemployment and social security benefits increase, while tax revenues tend to fall, thereby contributing to a smoothing of the business cycle. Within the euro area, the magnitude of such automatic fiscal stabilisers varies across countries, but is relatively large on average when compared to, for example, the United States, given the euro area countries’ more extensive welfare and tax systems.^[72]

Under exceptional circumstances, automatic stabilisers alone may be regarded as insufficient to cushion the very detrimental and prolonged impact of deep swings in the cycle.^[73] At the same time, the effectiveness of a discretionary fiscal stimulus is generally larger in such circumstances. While there is considerable uncertainty surrounding the size of short-term fiscal multipliers, recent evidence indicates that multipliers may be larger in deep recessions or financial crises or when monetary policy is constrained. In times of severe and extended crisis, the risks of misidentifying the occurrence of a shock and its depth are more limited and the risk of a policy mistake is therefore lower. At the same time, fiscal multipliers may be small (or even negative) when government debt levels are high and concerns about debt sustainability are increasing.^[74]

The fiscal stance impacts on both fiscal sustainability and stabilisation, implying a trade-off for expansionary policies. For example, while a fiscal stimulus would tend to raise output in the short run, it would at the same time add to debt and thereby increase sustainability risks. The size of these individual effects depends on the nature of the fiscal stimulus (e.g. whether it is permanent or temporary and the types of instrument applied), the starting fiscal position and the observed financial and macroeconomic conditions, etc.^[75]

A fiscal stance is usually assessed as appropriate if it provides a suitable balance between the sustainability and stabilisation objectives of fiscal policy. There is thus usually not just one “appropriate” fiscal stance, but rather a range thereof, all of which balance stabilisation and sustainability objectives, but with different weights on each objective. The theoretical and empirical literature does not provide clear guidance on where the optimal balance lies. It does, however, indicate that governments should respond more forcefully to sustainability constraints when their debt levels are high. Indeed, in such regimes, the impact of fiscal adjustment on output stabilisation is mitigated through confidence effects via the interest rate channel. Consequently, any recommendation regarding an “appropriate” fiscal stance requires an operationalisation of the sustainability and stabilisation objectives, which means taking into account the debt level of the country (see Box 3 for an evaluation of the European Commission’s metric to assess the appropriateness of the fiscal stance).

Gauging stabilisation needs is not straightforward. Generally, a government’s decision to increase or reduce support to the economy depends on its assessment of the state of the economy as measured, for example, by the level of the output gap and on the speed at which the government wishes to close it. However, as explained in Box 1, output gap estimates are subject to a high degree of uncertainty and may therefore give wrong signals in real time regarding stabilisation needs.^[76] For this reason, monetary policy has for a long time reduced the emphasis on unobserved indicators, such as the output gap, whose mismeasurement was one of the main driving factors behind the Great Inflation of the 1970s.^[77]

There is also no simple indicator for assessing whether a government’s debt is sustainable. Sustainability of government debt means that the accumulated debt can be serviced at any point in time.^[78] At the same time, any sovereign debt sustainability analysis (DSA) is sensitive to the assumptions applied.^[79] A comprehensive DSA framework should generally consider both debt dynamics and the level at which debt stabilises, test the resilience of the debt path under various adverse scenarios and account for other relevant indicators (e.g. a government’s gross financing needs, the structure of government debt, the scope for contingent liabilities, the quality of institutions and political risks). In its sustainability assessments under the European governance framework, the European Commission uses three indicators, aimed at summarising short, medium and long-term risks, alongside a more comprehensive DSA framework. Against this background, Box 2 provides a literature overview of how past (estimated) fiscal reaction functions have dealt empirically with the response to the stabilisation and sustainability objectives.

Specific elements of an appropriate fiscal stance at the euro area level

As at the national level, an appropriate aggregate fiscal stance for the euro area would seek a balance between the sustainability and stabilisation objectives. Notably, macroeconomic stabilisation needs would be gauged with respect to the size of the output gap for the euro area as a whole, while an assessment of debt sustainability risks would start by capturing developments in aggregate public debt.

However, the euro area aggregate fiscal stance is currently a purely mechanical concept, aggregating the fiscal stances at individual country level. In the absence of a centralised fiscal policy instrument, the euro area fiscal stance merely captures the sum of discretionary national policies. The direction of the euro area fiscal stance may therefore reflect very different developments at individual country level with, for example, fiscal tightening in some countries and fiscal loosening in others. The outcome may not always be optimal.

Inconsistencies between the assessment of the fiscal stance at the euro area and national level may arise for various reasons. Such inconsistencies can be caused by heterogeneous preferences at the central euro area level and the various national levels regarding the relative importance of the two policy objectives, i.e. ensuring fiscal sustainability and providing macroeconomic stabilisation. Therefore, the pursuit of national policies does not necessarily lead to an “optimal” outcome at the euro area level. In addition, problems may arise if previous shortfalls vis-à-vis SGP requirements and related fiscal sustainability concerns require a pro-cyclical fiscal tightening in some euro area countries, while other countries with fiscal room for manoeuvre are enjoying favourable macroeconomic conditions and do not therefore have an incentive to pursue expansionary policies. Indeed, in the context of the reviews of euro area countries’ draft budgetary plans, the Eurogroup has repeatedly stressed that, while the aggregate stance implied by the plans could be viewed as broadly appropriate, its composition across euro area countries was problematic because countries with remaining fiscal imbalances were falling short of SGP commitments, while countries with fiscal room for manoeuvre were not making full use of it.^[90]

In addition, a mechanical aggregation may not adequately capture the impact of national policies on the euro area economy. This is the case if a fiscal impulse in one euro area country spills over to other countries. Trade links between countries are the main transmission channel for such an impact.^[91] For example, if a fiscal expansion is conducted in a euro area country that has sizeable trade links with countries outside the euro area, the increase in domestic and euro area demand will be lower than if the same fiscal impulse were to occur in a euro area country whose trade links were mainly within the euro area. The assessment of the euro area fiscal stance, as a purely mechanical aggregation of national fiscal stances, and its macroeconomic impact on the euro area economy, may vary for a given fiscal impulse, depending on the magnitude of such spillover effects.

Importantly, the euro area aggregate fiscal stance can only be deemed “appropriate” if it safeguards the sustainability needs of all euro area countries. Since fiscal policy in EMU remains a national responsibility, sovereign debt sustainability must be ensured in all euro area countries, as sustainability problems in one country can have adverse implications for others as well as for the conduct of common policies at the euro area level. Sustainability indicators applied to the euro area aggregate debt ratio can thus be used only as a reference or for indicative purposes. In particular, a desired euro area fiscal stance may not necessarily be attainable via the aggregation of national fiscal policies if some countries face severe debt sustainability risks. In other words, the more divergent debt levels across euro area countries are, the greater is the likelihood that the aggregation of national policies will not lead to an appropriate stance for the euro area as a whole.

Limits of the current fiscal framework on the setting of the euro area fiscal stance

The EU’s current institutional framework entails no provisions or instruments to directly manage the aggregate euro area fiscal stance, which is a key difference between the euro area and federations such as the United States. In fact, fiscal policies are conducted in 19 euro area countries on the basis of national budgets and within different national fiscal frameworks. While the EU budget has common resources used, in particular, to promote economic and social cohesion among Member States, it is rather small in size (around 1% of the EU’s aggregate GDP), not specific to the euro area and not focused on macroeconomic stabilisation. At the euro area level, the institutional framework has been complemented by the European Stability Mechanism (ESM), a crisis management tool providing financial assistance to euro area countries experiencing or threatened by financing difficulties. Overall, however, the lack of common fiscal instruments at the centre stands in stark contrast to other federations such as the United States, where important policy instruments such as the setting of tax policies and important spending functions, e.g. defence and social and health insurance, operate at the federal level.

Notably, the SGP affects the aggregate fiscal stance indirectly rather than steering it directly. The euro area countries’ decentralised fiscal policies are coordinated by the SGP, which takes the economic cycle into account. As indicated in Box 4, the SGP contains a multitude of provisions for countries under both its preventive and corrective arms that modulate the required structural effort according to economic conditions and, to a lesser extent, the government debt ratio. Consequently, the SGP affects the aggregate euro area fiscal stance indirectly.

In addition, the SGP does not entail obligations for countries that have fiscal room for manoeuvre to contribute to a desirable aggregate fiscal stance. As indicated in Chart 1 above, the euro area aggregate fiscal stance is expected to be mildly expansionary in 2016. At the same time, while a number of euro area countries were assessed as being at risk of non-compliance with the SGP and therefore required additional fiscal tightening measures,^[99] others still have fiscal room for manoeuvre under the SGP rules. This notwithstanding, the SGP does not contain any provisions that incentivise these countries to use their existing fiscal room for manoeuvre to provide support to the euro area economy. The logic of the SGP is that it sets minimum requirements rather than targets for national fiscal policies, leaving it up to individual Member States to set themselves targets going beyond minimum requirements.

Recent legislative developments tend towards stronger coordination of the euro area fiscal stance. In particular, Regulation (EU) No 473/2013, which entered into force on 30 May 2013, includes common provisions for monitoring and assessing draft budgetary plans. Moreover, it requests the Council to issue policy recommendations for the euro area as a whole, including advice regarding the euro area aggregate fiscal stance. For example, to strengthen the scope of this advice, within the 2016 European Semester, i.e. the annual cycle of policy coordination and surveillance, the release of these recommendations for the euro area was frontloaded to November 2015.^[100] Member States should take these recommendations into account when defining their policy strategy. Thus, instead of actively steering the aggregate euro area fiscal stance, this frontloading enables the Commission and the Council to assess the draft budgetary plans of the individual euro area countries for the forthcoming year in the light of the recommended aggregate fiscal stance for the euro area as a whole.

Institutional considerations surrounding the future setting of the euro area fiscal stance

The European Fiscal Board

The newly created European Fiscal Board will advise the European Commission on the appropriateness of the fiscal stance at both national and euro area level within the rules of the SGP. As a follow-up to the Five Presidents’ Report, Commission Decision (EU) 2015/1937^[106] established a European Fiscal Board which – once fully operational – will provide an evaluation of the implementation of the provisions of the SGP and of the implications of budgetary policies at national level for the aggregate euro area fiscal stance.

The European Fiscal Board will not be equipped with policy tools to actively influence the setting of fiscal policies. It will rather contribute in an advisory capacity to multilateral surveillance in the euro area. However, the Commission Decision does not specify how the Board will perform its advisory function. In particular, it remains unclear how it would be involved in the procedures of the European Semester, the EU’s annual cycle of economic and fiscal policy coordination.

Given the envisaged institutional set-up, it is unclear how effectively the European Fiscal Board will be able to carry out its role. The fact that, according to the Commission Decision, the European Fiscal Board will operate within the European Commission’s institutional structure and not have a strong public voice is likely to undermine its credibility as an independent policy advisory institution.^[107]

From an operational point of view, the European Fiscal Board will need to develop a sound methodological framework on which to base its assessment of the fiscal stance. The Commission Decision also remains vague on how the Board shall perform its tasks in practice. While the assessment of Member States’ compliance with the provisions of the EU fiscal framework can build on well-established methodological foundations, this is not the case for the assessment of the appropriateness of the fiscal stance, in particular at the euro area level. Given the European Fiscal Board’s mandate to provide its assessments within the rules of the SGP, it will be important to ensure that SGP compliance in all Member States and debt sustainability risks form key elements of the assessment of the fiscal stance.

Options for a better setting of fiscal policies at the euro area level

In the context of a far-reaching overhaul of the institutional architecture of EMU, the Five Presidents’ Report proposes two fiscal instruments at the euro area level – a macroeconomic stabilisation function and a euro area treasury. The experience of the crisis has shown that, without monetary policy instruments at the national level, fiscal policies can become overwhelmed if country-specific shocks are very large and not well catered for by the shock-absorbing capacity of the economy and the financial sector. At the same time, as discussed in Section 4, the pursuit of national policies does not necessarily result in an appropriate stance at the euro area level. Central fiscal policy tools may therefore be useful to address idiosyncratic shocks more effectively and/or better steer the aggregate fiscal stance where appropriate.

A macroeconomic stabilisation function at the euro area level could complement automatic stabilisers at national level under certain conditions. While the ultimate design of a euro area macroeconomic stabilisation function would depend on political preferences, certain design principles should be adhered to in order to preserve incentives for sound fiscal policymaking and for addressing structural weaknesses at the national level. As emphasised in the Five Presidents’ Report, a euro area macroeconomic stabilisation function should neither be aimed at income equalisation nor lead to permanent transfers between Member States. It should take the form of automatic stabilisation and not aim at fiscal fine-tuning of the economic cycle. The stabilisation function would therefore not be a tool to actively steer the euro area fiscal stance, but rather reduce the need for euro area countries to address large country-specific shocks by using discretionary policies.

Mutual insurance against asymmetric shocks through a stabilisation function will require convergence in other policy areas. In this context, the Five Presidents’ Report emphasises that any move towards risk sharing needs to be preceded by a new convergence process towards more resilient economic structures in euro area countries.

In the longer term, a euro area treasury could be created and equipped with fiscal instruments to contribute to the setting of the aggregate euro area fiscal stance. The creation of such a central treasury would be the only way to effectively steer the euro area aggregate stance. However, to be effective, the budgetary capacity of this treasury needs to be sufficiently large to be able to react to economic shocks in the euro area. It is clear that the creation of such a central treasury function would require far-reaching institutional reform – in particular, a shift of sovereignty to the euro area level via an amendment to the Treaty on the Functioning of the European Union. A future euro area treasury would need to be democratically legitimised and accountable in order to carry out fiscal policy functions at the central level.

Conclusions

Recent institutional reforms have gone in the direction of strengthening the aggregate euro area perspective when assessing fiscal policies in the euro area. Following the “two-pack” reforms in 2013,^[108] the Council – based on the Commission’s assessment of euro area countries’ draft budgetary plans – now issues policy recommendations for the euro area as a whole, including advice regarding the appropriateness of the euro area aggregate fiscal stance. Member States should take into account this advice when defining their policy strategy in the context of the annual stability programme updates. At the same time, once operational, the newly established European Fiscal Board will advise the Commission on the appropriateness of the fiscal stance at both the national and euro area level within the rules of the SGP. The SGP, however, does not contain any requirement to contribute to the euro area-wide fiscal stance.

The assessment of the appropriateness of the euro area fiscal stance is not straightforward. Such an assessment needs to balance various objectives, notably with regard to sustainability and stabilisation, and to account for severe measurement problems, notably with respect to the output gap. While the European Commission’s approach to assessing the fiscal stance at the national and euro area level provides a useful basis for discussion, further work needs to be done to develop a sound methodological framework that is sufficiently robust to draw policy conclusions. Compliance with the provisions of the SGP and the timely correction of debt sustainability risks need to be key elements of the assessment of the fiscal stance.

The Stability and Growth Pact provides flexibility for Member States’ budgetary policies to react to cyclical fluctuations while ensuring adequate progress towards sound and sustainable fiscal positions. The full and consistent implementation of the SGP is crucial to ensure that markets trust the capability of the EU governance framework to effectively coordinate fiscal policies in EMU. At the same time, compliance with the SGP rules will enable Member States to rebuild fiscal buffers and increase their capacity to cushion future economic shocks effectively.

The decentralised fiscal framework, however, does not necessarily result in an appropriate stance at the euro area level. Two additional features for the future institutional architecture of EMU therefore appear desirable. First, the creation of a euro area macroeconomic stabilisation function to cushion large country-specific shocks, which can overwhelm national stabilisation capacities as experienced in the recent crisis. The aim of such a central macroeconomic stabilisation function would not be to actively steer the euro area fiscal stance but to provide an additional layer of automatic stabilisation, which would mitigate the need for discretionary policies at national level. A central stabilisation function would need to be well designed to preserve incentives for sound fiscal policymaking and for addressing structural weaknesses at the national level. At the same time, access to a prospective macroeconomic stabilisation function would need to be made conditional on significant progress on economic convergence in the euro area to achieve similarly resilient economic structures, ensuring that the stabilisation function does not imply permanent transfers between Member States. Increased risk sharing in the euro area would also have to be accompanied by more joint economic policy decision-making. Second, in the longer term, a euro area treasury could be equipped with fiscal policy tools to contribute directly to the setting of the euro area fiscal stance. This would require a shift of sovereignty to the euro area level via a Treaty amendment. Strong democratic legitimacy and accountability are crucial prerequisites for a euro area treasury that would carry out fiscal policy functions.