Contribution by Piero Cipollone, Member of the Executive Board of the ECB, to the Centre for European Reform’s annual economics conference on “A European path to higher economic growth”
Ditchley Park, 15 November 2024
Thank you for inviting me to discuss whether a “hot” economy can drive productivity growth.
A lot has been said recently about the structural reasons for the productivity gap between Europe and the United States, notably in Mario Draghi’s recent report.(1)
But this gap has worsened in the post-pandemic period, as productivity growth accelerated in the United States and stalled in the euro area (Chart 1). The hotter US economy largely explains this, whereas the euro area economy caught a cold as a result of the energy shock to which it was much more exposed.(2)
So today, I want to discuss how a strong recovery in productivity is critical for the euro area. Beyond its short-term benefit, it is also essential to avoiding a further erosion of the euro area’s economic potential. Monetary policy should take the medium and long-term effects of an excessively restrictive stance into account.(3)
The conditions for a cyclical recovery in euro area productivity
Earlier this year, I noted that unwinding supply shocks are creating an opportunity for recovery in the euro area economy, by making it possible to achieve lower inflation and higher growth simultaneously. I therefore argued for letting the recovery proceed by allowing for wages to rebound in the short term – thus recouping past real income losses. And I indicated that the improving inflation outlook should give us the confidence to dial back monetary policy restriction. This in turn would help the economy and productivity to pick up, with wages gradually moderating over the medium term to be consistent with trend productivity growth and our inflation target.(4)
So how far have we come on this path to a healthier economic environment?
Inflation
As expected, the unwinding of the energy shock has allowed headline inflation to continue its decline in recent months, falling to 2% in October (Chart 2). Although headline inflation will be bumpy in coming months because of energy base effects, we expect it to converge to 2% in the course of 2025.
Indicators of underlying inflation have also moderated somewhat (Chart 3).(5) Core inflation fell to 2.7% in October. Domestic inflation remains high, as services inflation tends to lag headline inflation, and is sustained by the wage catch-up in the short term. But the ECB’s measure of the Persistent and Common Component of Inflation (PCCI)(6), a more forward-looking indicator of underlying inflationary pressures that tends to be a better predictor of future inflation, stood at 2% in September, the last month for which this statistic is available.
This encouraging picture is further supported by market-based inflation expectations and fixings(7), which stand around 2% (Chart 4, left-hand panel). The option-implied risk-neutral distribution of average inflation over the next two years is now more balanced, around 2%, albeit assigning increasing probability to inflation rates below 2% (Chart 4, right-hand panel).
Wages
Lower inflation has contributed to a recovery in real income. This recovery has also been supported by the catch-up in wages, which has brought real wage developments more in line with those of productivity since the onset of the pandemic (Chart 5).
At the same time, unit labour costs growth has been buffered by lower unit profits and import prices. This has allowed the total supply deflator, which has provided a good early indicator of HICP inflation since the pandemic, to moderate to between 1.5% and 1.7% over the past year (Chart 6).
Moreover, the forward-looking wage tracker is consistent with a gradual moderation of wages in the coming year (Chart 7), in line with the outlook embedded in our projections, after rising further this year. This moderation should be supported by the gradual cooling down in labour market dynamics (Chart 8).
GDP growth
After several quarters of stagnation, euro area GDP growth has gradually increased, with annual GDP growth rising from 0.1% in the last quarter of 2023 to 0.9% in the third quarter of this year.
However, we are seeing contrasting signals.
First, domestic demand remained weak in the second quarter of 2024, as the small positive contribution of consumption was counterbalanced by a decline in investment (Chart 9). Initial indications suggest that consumption gathered pace in the third quarter, while investment contracted further.
Second, activity and economic sentiment have been very uneven across sectors, with manufacturing underperforming compared with services (Chart 10). This is also reflected in a reduction of inventories amid low capacity utilisation in the manufacturing sector, which has dragged down euro area growth over the past year (Chart 9).
These developments remain consistent with a gradual, consumption-led recovery, but this has not yet allowed for a turn in the investment cycle. Moreover, growth figures for the third quarter benefited from summer events such as the Olympics. Whether the recovery will firm up therefore remains to be confirmed and risks to economic growth are tilted to the downside.
Implications for productivity growth
The overall picture of a gradual and heterogenous recovery amid a resilient labour market also implies a slow cyclical recovery in labour productivity, with uneven developments across sectors (Chart 11).
This suggests that some factors have been slowing the upturn in consumption and holding back investment, delaying a cyclical recovery in productivity.
Risks to a cyclical recovery in euro area productivity
Three aspects warrant particular attention: households’ saving behaviour, the impact of monetary policy restriction and uncertainty associated with global economic policy.
Saving behaviour
Let me start with the first aspect. In recent quarters, households have allocated a portion of their increased real income to restoring their financial buffers or deleveraging. The saving ratio has increased, as household spending has not kept up with growth in real disposable income (Chart 12, left-hand panel). Empirical estimates suggest that high interest rates and a loss in households’ real net wealth have been key factors in this development (Chart 12, right-hand panel).
The effect is heterogenous across the household income distribution. Lower-income households – who are spending more relative to their income (Chart 13) – have accumulated almost no excess savings since the onset of the pandemic compared to the pre-pandemic trend (Chart 14).(8) Because of budget constraints, these households had to reduce their savings more than others in response to the energy price spike (Chart 15). They also had to rely more heavily on consumer loans, despite rising interest rates, to avoid reducing essential consumption.(9) This points to the need for lower-income households to deleverage and shore up their balance sheets as real income improves.
Conversely, higher-income households, who are more likely to be net savers, have benefited from higher interest rates. In the first half of this year, euro area non-labour income, such as net interest receipts and dividends, rose by 4.1%, which is more than twice the increase seen in 2015-19.
A tentative signal of a possible change in households’ recent saving behaviour is that recent data from the Consumer Expectations Survey are pointing to a decline in savings (Chart 12, left-hand panel). At the same time, the data confirm there is heterogeneity across the household income distribution (Chart 16, left-hand panel). Survey responses also indicate that households with an adjustable-rate mortgage already experienced an increase in their interest payments and a corresponding drop in their saving rate in the last two years, while those with fixed-rate mortgages increased their saving rate (Chart 16, right-hand panel).
Monetary policy restriction
This brings me to the second aspect: the effects of monetary policy restriction. After the sharpest monetary policy tightening in the ECB’s history – ten consecutive hikes that raised our policy rate by 450 basis points between July 2022 and September 2023 – followed by a period of holding rates steady, we have gradually dialled back restriction since June. Markets expect us to continue bringing rates down to a neutral level, within the range of natural rate estimates (Chart 17).(10)
However, it will take some time for the dialling back of monetary policy restriction to transmit to lending rates and loan demand. Lending rates have only just started to decline for new loans and stabilise for outstanding amounts (Chart 18). Lending to firms remains weak, while lending to households has shown signs of improvement from a low level (Chart 19).
The further transmission of our less restrictive stance will also depend on confidence that we will gradually but surely lower our policy rates further toward neutral levels. While the direction is clear, we are following a meeting-by-meeting approach, enabling us to adjust the pace and extent of rate cuts depending on our assessment of incoming data.
Dialling back monetary policy restriction should support investment. It should also provide relief to households, especially at the bottom of the wealth distribution(11), and thus boost the consumption-led recovery, supporting the positive effects from rising labour income.
At the same time, the path towards a neutral stance should also take into account that credit supply to firms is still very weak, amid tight credit conditions and signs of deteriorating bank asset quality due to an increase in underperforming and non-performing loans. In addition, the incipient recovery in lending to households has to be balanced against the high level of credit application rejections and signs of higher default rates on consumer loans. Moreover, bank lending conditions in the coming months could be further influenced by reduced liquidity in the system as the central bank balance sheet continues to shrink.
Risks from global policy developments
Let me now turn to the third key aspect: risks from global policy developments. Recent global political developments increase risks of disruption to the cyclical recovery of productivity in the euro area and have implications for how far we can support this recovery with our monetary policy, given the possible effects on inflation.
The prospect of higher trade tariffs being implemented by the United States could significantly weigh on activity, especially in manufacturing, because of the impact on euro area confidence, exports and investment. Moreover, political uncertainty in some euro area countries – which reduces the predictability of fiscal and economic policy – could weigh on consumer confidence and firms’ investment decisions. In countries with higher fiscal deficits, this could also increase Ricardian effects, where the support to economic activity from a loose fiscal stance is blunted by the expectation that fiscal policy will need to be tightened in the future.
These developments could in turn put downward pressure on euro area inflation, as a result of the impact on demand, global confidence, and the likely reorientation of third-country exports away from the US and to the euro area, which would weigh on import prices. However, these disinflationary effects could be countervailed by the depreciation of the euro exchange rate and tariff retaliation, which would increase the prices of imported goods.
An increase in US oil production, combined with the negative effects of tariffs on global activity and thus oil demand, could push oil prices down. This would counterbalance upward risks to oil prices arising from current geopolitical conflicts.
Implications for the euro area’s economic potential
Overall, this paints a picture of nascent recovery that is still fragile.
While there is some uncertainty around estimates of the level of the neutral rate given their wide range (Chart 17), downward risks to inflation have been increasing and risks to the economic outlook are tilted to the downside.
A risk management approach also needs to consider the medium to long-term negative consequences we would incur if our monetary policy proved to be out of step with the evolving balance of risks and thus remained too restrictive for too long.
It could be self-defeating to tolerate an economy running persistently below potential as an insurance against possible future inflationary shocks. Such a tactic could lower potential growth, thereby weakening the economy’s resilience to both demand and supply shocks.
Three key elements need to be considered when assessing the costs of running an economy cold – in other words, below its potential – for a long time. These are the effects on capital accumulation, human capital and structural reforms.
Consider capital accumulation.
Investment has been stagnating, or even declining, in the euro area in recent quarters, adding a cyclical shortfall to the existing structural gap with respect to the United States (Chart 20). This is likely to weigh on productivity growth given the role of capital accumulation (Chart 21).
While the weak productivity growth seen since the pandemic is potentially a short-lived phenomenon reflecting firms’ response to a temporary change in the relative prices of labour, capital and energy, the long-run trend may be permanently scarred by the current slow or declining pace of capital accumulation. The absence of investment growth not only reduces labour productivity by hampering capital deepening, but is also likely to weigh on total factor productivity growth by reducing the adoption and production of new technologies.(12)
Excessive restriction could also have implications for human capital.
Demographic trends and increased obsolescence of skills caused by technological transformation imply a shortage of deployable human capital. Under these conditions, any slack in the labour market and further underinvestment in adequately equipping the workforce would lead to a further loss of scarce resources that should instead be fully mobilised, not least to enable workers to update their skill sets and increase their employability in the light of fast-changing labour demand.
Finally, excessive restriction could have implications for our ability to address the structural dimension of the productivity gap. Structural reforms are hard to implement, as they imply costs for those that are displaced.(13) Their implementation is thus easier when the economy is running at potential, as confirmed by the literature.(14) This indeed creates room for public finance to reduce the risk that some end up worse-off as a result of the reforms, facilitating a Pareto efficient outcome. And it is easier to reallocate capital and labour when they are in high demand.
In summary, imposing more restriction than necessary on the economy in the short term could have transitory and also permanent costs, as it could exercise significant negative influence on total factor productivity dynamics via weak capital accumulation(15), depletion of human capital and a slower pace in implementing structural reforms. This would reduce economic potential, and thus affect the speed limit of the economy – that is, the level at which GDP growth becomes inflationary.
Conclusion
Let me conclude.
In the euro area, labour productivity tends to be strongly affected by the business cycle.(16) For productivity growth to rebound fully, we need the nascent signs of economic recovery to firm up.
The unwinding of the energy shock and the associated decline in inflation have allowed us to start dialling back monetary restriction. This should support investment and reinforce the effect of rising real incomes on consumption, especially for lower-income households.
The current balance of risks suggests that we can and should reduce further the current level of monetary policy restriction. The pace and extent of this reduction will depend on the incoming data.
A cyclical recovery in productivity would support the disinflationary process in the euro area and reduce the risk of permanent scars on the euro area’s economic potential. So we should not be more restrictive than what is necessary to ensure the timely convergence of inflation to our 2% target.
We do not want an overheated economy. But we do want to see our economy reach the right temperature, which would certainly be hotter than it has been recently.
Thank you for your attention.
