‘Difficult times warrant difficult but necessary measures’, CBC governor says

The Governor of the Central Bank of Cyprus (CBC) Constantinos Herodotou on Friday used his keynote address at the 14th Limassol Economic Forum to provide insights into the economic outlook for the euro area, stressing that difficult measures are necessary to combat inflation.

Initially, Herodotou expressed gratitude to the organisers for the invitation to this significant gathering, acknowledging the Limassol Economic Forum’s track record of success.

He also noted that he was specifically tasked with presenting an assessment of the economic prospects for one of the world’s most influential economic regions, the euro area.

Herodotou stated that “amidst the continuous waves of shocks and high uncertainty, the euro area remains a cornerstone of the global economy, exemplifying both the challenges and opportunities of integrated economies”.

From the aftermath of the great financial and sovereign debt crises to the unforeseen impacts of the global pandemic and the ongoing repercussions of the Ukraine conflict, the euro area has proven its resilience.

“Nevertheless, based on the combined strength and collective decision-making of its member states, the euro area has shown resilience, ensuring that financial stability is preserved and economic recovery is steady and sustainable,” he said.

However, Herodotou acknowledged that the euro area is currently facing a slowdown in economic growth in 2023.

During the first half of the year, the euro area economy grew by a modest 0.1 per cent on a quarter-to-quarter basis.

In addition, recent data indicates a similar performance for the third quarter. Factors such as reduced residential and business investments due to tighter financing conditions, coupled with diminished demand for euro area exports, have acted as impediments to economic growth.

Herodotou highlighted the Purchasing Managers’ Index (PMI), which measures market conditions as perceived by purchasing managers surveyed monthly. The PMI data revealed that economic trends in the manufacturing sector are contracting, while the services sector, which had been growing until July 2023, has also shifted into contractionary territory.

“Based on the European Central Bank (ECB) September 2023 projections, which are the most recent projections available, the economic activity is expected to regain momentum at the beginning of 2024,” the CBC governor said.

“This will be fuelled by projected increases in real income due to decreasing inflation, growing wages, a robust European labour market and recovering foreign demand,” he added.

Moreover, he noted that according to the projections released in September, the euro area economy is expected to grow by 0.7 per cent in 2023, 1.0 per cent in 2024 and 1.5 per cent in 2025.

Addressing inflation, Herodotou noted a notable decline in headline inflation in the euro area, dropping from 5.2 per cent in August to 4.3 per cent in September.

The ECB’s September projections suggest that inflation will further decrease from 8.4 per cent in 2022 to 5.6 per cent in 2023 and 3.2 per cent in 2024, ultimately reaching 2.1 per cent in 2025.

This trend aligns with the ECB’s commitment to maintaining price stability with a 2 per cent inflation target over the medium term.

To combat inflation, central banks rely on adjusting interest rates. Herodotou highlighted that the ECB Governing Council had implemented ten successive interest rate increases since July 2022, amounting to a total increase of 450 basis points.

He explained that in its most recent assessment, the “Governing Council considers 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”.

However, Herodotou emphasised that uncertainties persist in the euro area. Recent energy price increases could transmit inflationary pressures throughout the economy. Additionally, elevated wages and profit margins observed in the region require close monitoring, even though they are expected to normalise.

“The liquidity conditions in the euro area banking system is another area to monitor, since it plays a role in transmitting monetary policy and, consequently, affects inflation,” he said.

“These uncertainties are the reason why I believe the ECB Governing Council approach to be data-dependent in its interest rate decisions, is indeed the right one,” he added.

In other words, Herodotou continued, “determine the appropriate level and duration of its tightening policy stance, based on incoming economic and financial data and the consequent projections”.

In terms of fiscal policy, Herodotou stressed its complementary role in supporting monetary policy, especially during challenging periods.

Governments, he said, should implement targeted fiscal measures to support vulnerable segments of society and avoid broad measures that may exacerbate inflation.

Herodotou also emphasised the symbiotic relationship between price stability and financial stability, highlighting the importance of a stable financial system to achieve price stability through monetary policy.

In his closing remarks, Herodotou underscored the pivotal juncture at which the euro area finds itself and the importance of prudent measures to control inflation.

“Difficult times warrant difficult but necessary measures. The cost of leaving inflation untamed, is much higher to households, businesses and the entire economy, whereas tightening monetary policy should eventually revert down to neutral, when the 2 per cent inflation target in the medium term is deemed sustainable,” Herodotou stated.

“The decisions we make today about our economy will shape the economic trajectory for years to come,” he added.

“By working together with a common vision, remaining focused on the appropriate policies, the euro area, including of course Cyprus, can forge a future that is prosperous and sustainable,” the CBC governor concluded.