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ECB official praises Cyprus economy — notes fiscal tightening effects slow to materialise

de guindos
CBC governor Constantinos Herodotou with Luis de Guindos

The Vice President of the European Central Bank (ECB) Luis de Guindos on Wednesday praised the notable improvement in Cyprus’ economy and its recent upgrade by two credit rating agencies during a meeting with the Governor of the Central Bank of Cyprus (CBC), Constantinos Herodotou, in Nicosia on Wednesday morning.

The two officials also emphasised the close collaboration between the CBC and the ECB.

Herodotou expressed his gratitude for de Guindos’ visit to Cyprus, highlighting its significance as evidence of the strong relationship between the ECB and the Central Bank of Cyprus.

He added that this visit provides a unique opportunity not only to discuss the broader dynamics of the Eurozone but also the recent progress and challenges facing the local Cypriot economy.

“Our dialogue, which delved deep into the current financial landscapes and future strategies, was insightful and productive,” Herodotou said.

“The ECB has also acted proactively in managing the challenges facing the Eurozone, including addressing high inflation rates,” he added.

The Vice President of the ECB expressed his pleasure at being in Cyprus, underscoring the close cooperation between the two institutions.

In addition, he conveyed his anticipation for his meeting with the President of the Republic of Cyprus and also acknowledged the impressive improvement in the economy and banking sector of Cyprus.

“We have recently seen two credit rating agencies upgrading Cyprus, which is very positive. It is a clear indication of improvement in both the economy and the banking sector of Cyprus,” de Guindos said.

Moreover, the Vice President of the ECB also acknowledged Herodotou’s valuable contribution to the ECB’s Governing Council, stating that he brings a productive perspective and collaboration to their discussions. He expressed his anticipation for continued cooperation in the future.

The Vice President of the ECB was the keynote speaker at the first annual conference of the CBC, with the theme “The Role of Monetary Policy in Addressing Inflationary Pressures,” which took place in Limassol on Wednesday afternoon.


Herodotou highlights the need to tackle high inflation

In his welcome address at the conference, the CBC governor highlighted the significance of addressing high inflation and its impact on society and the economy.

Herodotou stressed that high inflation erodes the purchasing power of income and affects individuals, families, businesses, and the overall economy. Left unchecked, it could lead to a vicious cycle of rising prices and inflation expectations.

“Imagine a world where the cost of basic necessities, such as food, housing, and healthcare, increases by 10 per cent or 15 per cent or even more every year,” Herodotou said.

“A number of Eurozone countries witnessed such levels of inflation last year. Households would suffer this cost, and the lower income households suffer the most,” he added.

Uncontrolled inflation can result in economic uncertainty, leading businesses to postpone investments and potentially stifle innovation, job creation, and economic growth.

“For the average citizen also, long-term planning becomes a challenge,” the governor said.

“How does one save for a child’s education or one’s retirement when the future value of money could be so uncertain,” he asked.

Herodotou also spoke on the need to maintain price stability, which is essential for societal well-being.

Price stability, he explained, ensures that individuals and businesses can preserve the value of their income and wealth, fostering economic growth, job creation, and prosperity.

The governor also highlighted the symbiotic relationship between price stability and financial stability.

“The pursuit of price stability through monetary policy, and of financial stability through macroprudential policy, are to a large extent complementary. The primary objective of the ECB is price stability, namely a two per cent inflation rate over the medium term,” Herodotou said.

“However, monetary policy needs to take financial stability and the stance of macroprudential policy into account. Monetary policy and macroprudential policy operate through common transmission channels, meaning that the scope for interaction between the two policy spheres is wide,” he added.

He noted that the Central Bank of Cyprus, for example, increased the countercyclical buffer to enhance the banking sector’s resilience.

Additionally, the governor acknowledged that the ECB’s monetary policy has been effective in combating inflation and keeping inflation expectations anchored. While inflation remains above the 2 per cent target, the transmission of monetary policy decisions is still in progress.

The governor also shared Cyprus’s economic projections, indicating a significant reduction in inflation, continued economic resilience, and declining unemployment. These projections provide a positive outlook for the country’s economic performance.

“As regards the inflation outlook in Cyprus, according to the latest CBC projections, also of September 2023, a significant reduction in the inflation rate is expected from 8.1 per cent in 2022 to 3.9 per cent in 2023. This downward trend is anticipated to continue, with inflation decreasing to 2.7 per cent in 2024 and 2.0 per cent in 2025,” Herodotou said.

“According to the same projections, the Cyprus economy will continue to exhibit resilience, with the GDP growth rate expected to reach 2,4 per cent, 2.7 per cent and 3.1 per cent, in each year from 2023 to 2025,” he added.

He also noted that unemployment in Cyprus is expected to decrease to 6.3 per cent in 2023 compared to 6.8 per cent in 2022. In the years 2024-25, unemployment is expected to stand at 5.9 per cent and 5.6 per cent, respectively.

Herodotou acknowledged the persisting uncertainties in the eurozone, such as energy price spikes and wage and profit margin observations. These uncertainties may impact inflation and the overall economic landscape.

“The elevated wages and profit margins observed in the euro area last year, need to be monitored closely, even though they are currently expected to normalise,” the governor said.

“Also the liquidity conditions in the euro area banking system can play an important role in the transmission of monetary policy and therefore inflation,” he added.

Herodotou concluded by saying that successfully addressing current challenges, including inflation, can pave the way for structural reforms and a transition to a technologically advanced economic environment.

“For instance, an economic environment characterised by stable price and financial conditions can support the much-needed efforts and investments related to structural reforms,” he said.

“These reforms can be directed to preserve and enhance the competitiveness of our economies, through a transition to a more technologically advanced environment,” Herodotou added, noting that “this can be beneficial to all stakeholders of the economy and all members of society”.


Luis de Guindos on monetary policy, challenges, concerns

In his keynote speech at the same conference, ECB Vice President Luis de Guindos, Vice-President of the ECB, provided an overview of the economic outlook for the euro area, before detailing how the ECB has adjusted its monetary policy to this outlook.

He also discussed the transmission of the ECB’s monetary policy in the current environment and the sources of uncertainty that appear particularly relevant at this stage.

De Guindos noted that economic activity has been stagnant in the first half of the year, primarily due to weaker foreign demand and tight financing conditions. The manufacturing sector has been particularly affected, and the services sector is also starting to be impacted.

He also noted that the “labour market remains resilient despite the slowdown in activity, with the unemployment rate standing at its historical low of 6.4 per cent in August”.

“However, there are signs that labour market momentum is slowing as the economy weakens, he said.

“The employment Purchasing Managers’ Index declined significantly between the second and the third quarters of 2023, despite a slight uptick in September,” he added, noting that “the services sector, which has been a major driver of employment growth since mid-2022, is now also creating fewer jobs”.

Moreover, he mentioned that ECB staff revised down GDP growth projections for the euro area, especially for the current year and the next, due to tightening financing conditions and weaker international trade. Growth is expected to recover in the medium term, supported by rising wages and falling inflation.

The ECB Vice President also referenced the fact that inflation has decreased from its peak last year but remains relatively high. Underlying price pressures remain strong, with labour costs contributing to domestic inflation. Additionally, he noted that longer-term inflation expectations stand at around 2 per cent, although some indicators have increased recently.

In terms of the ECB’s monetary policy response, De Guindos emphasised the ECB’s commitment to bringing inflation back to the 2 per cent target.

“Having raised interest rates by a total of 450 basis points since July 2022, we consider that the key ECB interest rates have now reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target,” de Guindos said.

“Our reaction function will continue to serve as the framework for future decisions, and we will continue to follow a data-dependent approach to determining the appropriate level and duration of a restrictive monetary policy stance,” he added.

However, he explained that the transmission of monetary policy to financing conditions has been strong, but the impact on the real economy is slower, with some effects yet to materialise.

The speed and nature of transmission are uncertain due to the unprecedented nature of the current monetary policy cycle and the unique shocks affecting the euro area.

“Transmission to the bank lending channel is likely to continue unfolding as lenders may become more prudent in light of rising funding costs and a slowing economy,” he said, noting that “interest rates on outstanding debt will continue to increase as loans are progressively repriced”.

“All in all, in my view, the transmission of our policy tightening to financing conditions seems to be well underway,” he added.

What is more, De Guindos highlighted the downside risks to economic growth in the euro area, particularly if monetary policy has a more forceful impact or if the global economic environment weakens further.

On the inflation side, weaker demand or fiscal policy challenges could put downward or upward pressure on prices.

The ECB Vice President wrapped things up by saying that the transmission of the ECB’s monetary policy tightening is occurring but remains uncertain in terms of speed and scope due to the unique nature of the current rate hike cycle and lingering economic uncertainties.

Long-term structural changes, such as shifts in trade patterns, climate-related risks, and geopolitical factors, could also impact inflation.

Therefore, he continued, historical comparisons and model-based estimates should be complemented by real-time monitoring.

“While there are signs of the strength of the first leg of the transmission, a substantial share of the transmission from financing conditions to the real economy is expected to still be in the pipeline, subject to longer lags,” de Guindos said.

“This reinforces the need for a data-dependent approach to determining the appropriate level and duration of a restrictive monetary policy stance,” he concluded.

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