Mario Draghi gave the keynote speech at the Frankfurt European Banking Congress this morning in which he focused on the strong outlook for the Eurozone economy and how his monetary policy is playing a vital role. The speech was peppered with upbeat phrases and adjectives like solid, robust, unabated, endogenous propagation, resilient, remarkable and ongoing. According to Draghi.
The euro area is in the midst of a solid economic expansion. GDP has risen for 18 straight quarters, with the latest data and surveys pointing to unabated growth momentum in the period ahead. From the ECB’s perspective, we have increasing confidence that the recovery is robust and that this momentum will continue going forward.
Draghi is confident that future growth will be unabated for three reasons.
- Previous headwinds have dissipated;
- Drivers of growth are increasingly endogenous rather than exogenous; and
- The Eurozone economy is more resilient to new shocks.
In terms of previous headwinds, Draghi notes that global growth and trade have recovered, while the eurozone has de-leveraged.
For some years global growth and world trade have been a drag on the recovery. Now, we are seeing signs of a sustained expansion. Global PMIs remain strong. The share of countries in which growth has been improving relative to the previous three years has risen from 20% in mid-2016 to 60% today. And this has fed through into a rebound in world trade, which is growing at its strongest annual rate in six years, and may well become a tailwind going forward.
Domestically, a key headwind in the past has been the necessary deleveraging by firms and households. But this is also now diminishing as debt returns to more sustainable levels. For the euro area, gross corporate debt to value added is now roughly back to its pre-crisis level. In vulnerable countries the decline has been steeper. In Spain, corporate debt has fallen from 215% of gross value added in early 2012 to close to 150% today – the same level it had at the end of 2004. Italian firms have seen their debt ratio fall by around 30 percentage points since end 2012, returning to the same level as in mid-2007.
For households, gross indebtedness is also edging down and now stands just below its mid-2008 level. And importantly for the recovery, household deleveraging is now happening largely “passively” – i.e. through nominal growth – rather than “actively”, that is, through paying down debt or write offs.
Regarding the second reason, Draghi sees the exogenous factors of falling oil prices and monetary policy have less impact as growth has become self-sustaining. This sort of confidence from central bankers is often mistimed, but this is Draghi’s assertion.
Now, we see more signs that growth is “feeding on itself”, i.e. spending multipliers and endogenous propagation are again supporting activity. This cycle is most evident for private consumption, which has remained robust even as oil prices have risen by about 30 dollars since the start of 2016. Consumption is being supported by a virtuous circle between rising labour income and rising employment. Employment in the euro area has reached its highest level ever, while unemployment has fallen to its lowest rate since January 2009. Importantly, this has taken place against the backdrop of a rising participation rate, which is now 2 percentage points above its pre-crisis level… The fact that unemployment has fallen so much while labour participation has been rising is a remarkable success story. As consumption has strengthened and spending multipliers have taken hold, investment has also followed with a lag. Since 2016, investment has contributed almost 45% to annual GDP growth, compared with under 30% in the two years previously.
Turning to his third reason, Draghi believes that two factors are behind the Eurozone’s increasing reliance to new shocks. First, the increasing convergence between the performance of Eurozone countries, for example, in terms of GDP growth and employment, and credit conditions. Second, the resilience of the financial sector. We will refrain from making any remark about Deutsche Bank or a big chunk of the Italian banking industry, but this was Draghi’s comment.
The other trend is the growing resilience of the financial sector. The total capital ratio of significant banks has increased by more than 170 basis points since early 2015. Their return on equity has risen from 4.4% at the end of 2015 to 7.1% at the start of this year, even as their leverage ratios have declined. All banks have benefited from the upward trend in returns on assets since the start of our monetary policy easing in 2014, although in some cases starting from low levels. Clearly this trend hides some variation among banks, which is largely driven by differences in their business models.
Low-for-long interest rates might contribute to a build-up of financial risks, and this has to be carefully monitored. At present we do not see systemic risks emerging at the euro area level. If there are some local pockets of risk, the defence lies in micro-prudential and macro-prudential policies, not changing area-wide monetary policy. Furthermore, in such an environment any backtracking on financial regulation would be a mistake, as the pre-crisis experience has shown.
Draghi would be rare amongst central bankers if he did see systemic risks, just like they never see asset bubbles, but we digress. One area where Draghi had to acknowledge a less than stellar performance was inflation, given the misguided view that reducing purchasing power is a good thing. He characterised progress as “incomplete and partial”. However, he sees two reasons for optimism.
Two indicators are important for gauging the durability of inflation. The first is the outlook for growth, since this helps us assess whether inflation will continue to rise as we expect. The second is underlying inflation. This allows us to assess whether inflation will stabilise around our aim once the effects of volatile factors, such as oil and food price swings, have faded away.
The growth outlook is now clearly improving, for all the reasons I have mentioned. But the underlying inflation trend remains subdued. According to a broad range of measures, underlying inflation has ticked up moderately since the start of this year, but it still lacks clear upward momentum. A key issue here is wage growth. Since the trough in mid-2016, growth in compensation per employee has risen, recovering around half of the gap towards its historical average. But overall trends remain subdued and are not broad-based.
On the ECB’s asset purchase program, Draghi stated that the reduction in monthly purchases from 60 billion Euros to 30 billion reflects the “growing confidence” in the economy. Asset purchases could be extended beyond September 2018 if there has not been a “sustained adjustment in the path of inflation”. Indeed, he noted that the reduced pace of purchases coupled with the extension of the time horizon had essentially left financial conditions unchanged. Having talked up the Eurozone recovery and prospects, Draghi urged politicians to do their part, a not so subtle way of taking credit for recent successes.
With the recovery ongoing, now is the right moment for the euro area to address further challenges to stability. This means actively putting our fiscal houses in order and building up buffers for the future – not just waiting for growth to gradually reduce debt. It means implementing structural reforms that will allow our economies to converge and grow at higher speeds over the long term. And it means addressing the remaining gaps in the institutional architecture of our monetary union.
So Draghi is very bullish, although we suspect his Eurozone recovery is somewhat more fragile than he would admit, but time will tell. Mark Ostwald, global strategist at ADM ISI, commenting on the timing of Draghi’s speech noted:"It comes ahead of next week's 'account' of the October council meeting, which may well highlight that Signor Draghi was rather economical with the truth about how many council members wanted to signal a specific end point for the QE programme, as has been more than evident in speeches since."