Flash Economics 22 February 2018 - 212 Patrick Artus Tel. (33 1) 58 55 15 00 patrick.artusnatixis.com PatrickArtus www.research.natixis.comIs the hierarchy of ECB priorities the right one? The hierarchy of ECB priorities is now clearly: 1- Meeting the inflation target; 2- Stimulating growth; 3- Ensuring financial stability. In an economic environment where equilibrium inflation spontaneously is lower than the inflation target, and where there are risks of financial instability (abnormal squeezing of risk premia, high volatility in financial markets), would it not be more reasonable for financial stability to become the ECBs prime objective? Macroprudential policies (regulation of financial intermediaries) seem incapable of preventing the very expansionary monetary policy from generating financial instability. Distribution of this report in the United States. See important disclosures at the end of this report. Flash Economics 2 The present hierarchy of ECB priorities The ECB currently maintains a very expansionary monetary policy (Charts 1A and B), with the stated objective of bringing euro-zone inflation back to the 2% target (Chart 2). -1012345-101234502 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 1A Euro zone: Euro repo rate and interest rate on banks deposits at the ECB (as %)Euro repo rateInterest rate on banks deposits at the ECBSources: Datastream, ECB, Natixis -150-100-5005010015020025004008001,2001,6002,0002,4002,8003,20002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 1B Euro zone: Monetary base (in EUR bn)In absolute terms (LHS)Month-on-month change (RHS)Sources: Datastream, ECB, Natixis-1012345-101234502 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 2 Euro zone: Core* CPI and CPICPI (Y/Y as %)Core* CPI (Y/Y as %)Sources: Datastream, Eurostat, Natixis(*) Excl. energy and foodThis expansionary ECB monetary policy has resulted in abnormally low interest rates (Chart 3), thereby stimulating domestic demand and growth in the euro zone (Chart 4). -6-4-202468-6-4-20246802 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 3 Euro zone: Nominal GDP and interest rate on government bondsNominal GDP (Y/Y as %)Euro zone excl. Greece: 2-year govt. interest rate (as %)Euro zone excl. Greece: 10-year govt. interest rate (as %)Sources: Datastream, Eurostat, Natixis -6-4-20246-6-5-4-3-2-10123402 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 4 Euro zone: Domestic demand and real GDP growth (Y/Y as %)Domestic demandReal GDPSources: Datastream, Eurostat, NatixisFlash Economics 3 As a consequence of this very expansionary monetary policy, financial instability has appeared: abnormally low risk premia (on corporate bonds, covered bonds, Charts 5A and B), high volatility in financial markets (e.g. equity markets, Chart 5C, foreign exchange markets, Chart 5D). 05010015020025030035002004006008001 0001 2001 4001 60002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 5A Euro zone: High Yield and Investment Grade* credit spreads (asset swaps, in bp)High Yield (LHS)Investment Grade* (RHS)Sources: Datastream, iBoxx, Natixis(*) AAA + AA + A + BBB-50050100150200250-5005010015020025002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 5B Euro zone: Spread against swaps on covered bonds (in bp)Sources: Datastream, iBoxx, Natixis40608010012014016040608010012014016002 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 5C Stock market index: Euro Stoxx (2002:1 = 100)Sources: Datastream, Natixis-300-200-10001002000,60,81,01,21,41,602 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 5D Euro zone: Euro/dollar exchange rate and net open position in the euroEuro/dollar exchange rate (EUR 1 = USD., LHS)Net open position in the euro (in thousands of contracts: long-short, RHS)Sources: Datastream, Bloomberg, NatixisAll this reveals to us the hierarchy of the ECBs objectives: 1- First, meeting the inflation target; 2- Next, as long as inflation remains below the 2% inflation target, stimulating growth; 3- Ensuring financial stability, which is apparently not a matter of prime concern for the ECB. Flash Economics 4 Is this hierarchy of ECB objectives reasonable? The euro zone is currently in a structural situation of low inflation (Chart 2 above), due to the disappearance of Phillips Curve effects and the resulting low level of growth in unit labour costs (Chart 6). -202468-20246802 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18Chart 6 Euro zone: Unit labour costs (Y/Y as %)Sources: Datastream, ECB, NatixisMoreover, as we have just seen, there is a fairly high risk of financial instability. Lastly, the unemployment rate is returning to the level of the structural unemployment rate, as shown by the major increase in recruitment difficulties (Chart 7). -2-101234567891011121302 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19Chart 7 Euro zone: Unemployment rate and proportion of companies experiencing recruitment difficulties* (as %)Unemployment rate (LHS)Prop