Outlook for the euro space financial system and monetary stability

Introductory remarks by Luis de Guindos, Vice-President of the ECB, on the 34^th version of “The outlook for the financial system and finance”, organized by the European Home – Ambrosetti

Cernobbio, 1 April 2023

Monetary stability is important to the ECB’s main goal of worth stability. The occasions of the previous few weeks have reminded us of the advantages of robust and harmonised banking regulation and the significance of finishing the banking union. We’re carefully monitoring developments in monetary markets and monetary establishments.

The euro space banking sector is resilient, with robust capital and liquidity positions which are effectively above the minimal necessities. And banks at the moment meet a really massive portion of the liquidity necessities with essentially the most liquid asset obtainable – reserves held on the central financial institution. This example may be very totally different to 2008 and 2009. Since then, harmonised European banking supervision has been arrange and now we have made good progress in implementing the worldwide regulatory reform agenda that was launched within the aftermath of the worldwide monetary disaster. However there isn’t a room for complacency.

Latest occasions in monetary markets have heightened uncertainty, which can hamper the transmission of our financial coverage throughout the euro space. And we’re prone to see an additional improve in banks’ price of funding, a tightening of credit score requirements and a deceleration within the progress of lending volumes. There may be a drop in client and investor confidence and decrease general mixture demand. Nonetheless, it’s too early to attract conclusions in regards to the impression all of this may have on progress and inflation. The turbulence could be short-lived, but when amplification results do emerge, they’ll present up within the information.

On this context of heightened uncertainty, our strategy to bringing inflation right down to our 2% medium-term goal will stay data-dependent. As we clarified in our newest press convention, our future coverage path can be decided by our evaluation of the inflation outlook in mild of the incoming information, the dynamics of underlying inflation and the energy of financial coverage transmission. We consider that headline inflation is prone to decline significantly this 12 months, whereas underlying inflation dynamics will stay robust.

We got here from double-digit month-to-month inflation within the euro space in direction of the tip of 2022. Inflation has been edging downwards, falling to eight.5% in February, to six.9% in March (flash estimate), and we count on it to proceed to say no steadily due to decrease vitality costs, the easing of provide bottlenecks and a slight appreciation of the euro. The truth is, vitality inflation peaked in 2022 and needs to be round zero and even unfavorable this 12 months. However components contributing to inflation are altering – meals and non-energy industrial items inflation will doubtless solely attain its peak in 2023, sustaining the strain on core inflation, which edged as much as 5.7% in March (flash estimate).

We’ve got to pay specific consideration to components that might pose upside dangers to inflation. The primary of those is rising wage progress, which has a major impression on the worth of companies. There aren’t any clear indicators of a self-sustaining wage-price spiral, however these dangers should be monitored. Labour markets are tight, unemployment is low and other people really feel safe of their jobs, which may be very constructive. However compensation for prime inflation is a essential theme in wage negotiations and nominal wages are anticipated to develop in 2023. We’re additionally carefully monitoring underlying inflationary pressures stemming from income. Income margins have grown rather more than labour prices in some financial sectors. The suggestions between larger revenue margins, larger wages and better costs might pose extra lasting upside dangers to inflation.

Developments in China are one other issue that deserves our consideration. China’s reopening is clearly constructive for progress, however a stronger than anticipated rebound might enhance overseas demand and add to commodity worth pressures.

We additionally want to concentrate to how fiscal help measures develop over time. Governments’ discretionary coverage response to the excessive vitality costs and inflation was near 2% of GDP in 2022 and is anticipated to be on the similar degree this 12 months. Fiscal measures have a tendency to cut back inflation within the quick time period, however we count on the other to be true as they begin to be withdrawn in 2024, resulting in larger inflation in 2024 and 2025.

This discretionary fiscal help initially will increase GDP progress and helps households’ nominal disposable earnings. Nonetheless, solely a small share of the help is definitely focused at lower-income households. Because the vitality disaster turns into much less acute, it will be significant that governments begin rolling again fiscal measures. The elevated burden on public funds, particularly if the help is prolonged by way of extra long-lasting measures, could pose extra challenges in Europe.^[1] Public debt ratios are larger than prior to now, following the decided and efficient fiscal coverage response to the pandemic, and debt servicing prices are larger as effectively. Member States also needs to pay attention to the European Fee’s fiscal coverage steerage for 2024.

Turning to progress, we moved away from a baseline situation with a technical recession on the flip of the 12 months, as financial exercise proved to be extra resilient than anticipated on the finish of 2022. In our March projections, the outlook for progress was revised up, to a mean of 1% in 2023. Nonetheless, these projections have been finalised earlier than the occasions of the previous few weeks, which are actually including uncertainty to our assessments. Nonetheless, decreased issues about vitality shortages and worth will increase, coupled with the continued resilience of the labour market, are anticipated to help exercise over the approaching quarters. In brief, the expansion outlook stays weak, but it surely has improved considerably.

On the Governing Council assembly in March, we determined to extend the three key ECB rates of interest by 50 foundation factors, according to our willpower to make sure the well timed return of inflation to our 2% medium-term goal. As a part of the financial coverage normalisation course of, from the start of March, our asset buy programme portfolio has been declining at a tempo of €15 billion monthly, on common, and it’ll proceed to say no at this tempo till the tip of June 2023, whereas its subsequent tempo can be decided additional time. Uncertainty has elevated, so we’re monitoring present market tensions carefully and stand prepared to reply as essential to protect worth stability and monetary stability within the euro space.

However let me return to monetary stability. Only a few weeks in the past, earlier than tensions in monetary markets emerged on either side of the Atlantic, the general enchancment within the outlook for progress and inflation was supporting overly benign macro-financial expectations on the a part of banks and monetary market members.

Regardless of rising funding prices, financial institution profitability has improved, pushed by considerably larger web curiosity earnings whereas impairments and provisions have been muted up to now. General, from a system-wide perspective, euro space banks are reasonably uncovered to rate of interest danger. Most are literally positioned to initially profit from growing rates of interest, which enhance web curiosity margins. On common, mortgage e-book repricing tends to greater than offset larger funding prices and mark-to-market losses on fastened earnings securities. It’s inevitable nevertheless that, with the tightening of financing circumstances and according to our coverage goal, lending dynamics are weakening and will weigh on financial institution profitability going ahead.

In fact, sure financial institution enterprise fashions could also be extra weak to this transition. However, in our view, vulnerabilities within the monetary system prevail within the non-bank monetary sector, which grew quick and elevated its risk-taking in the course of the low rate of interest atmosphere. Credit score and liquidity danger stay excessive, making the sector extra weak to market volatility and an abrupt repricing in monetary markets. Regardless of some current de-risking, structural liquidity mismatch prevails within the non-bank monetary sector and market corrections might be amplified by pressured promoting into illiquid markets.

It’s important that coverage reforms are pursued to deal with these vulnerabilities. Precedence needs to be given to insurance policies that assist construct resilience within the sector, resembling by decreasing liquidity mismatch, mitigating danger from leverage, and enhancing liquidity preparedness throughout a broad vary of establishments.