Annual Report 2018 Contents The year at a glance 4 The year in figures 6 1 Economic activity continued to expand at rates above potential, while cost pressures strengthened and broadened 8 1.1 A less balanced global expansion 8 1.2 Economic growth moderated, but remained consistent with an ongoing expansion 11 Box 1 Population ageing and its fiscal impact 16 1.3 Inflation on a higher path 20 1.4 Favourable financing conditions supported credit and money growth 23 2 Monetary policy: patience, prudence and persistence remain paramount 27 2.1 Winding-down of net asset purchases, while keeping policy accommodation ample 27 Box 2 Euro area sovereign bond market liquidity and implementation of the public sector purchase programme 31 Box 3 The effect of the corporate sector purchase programme on the financing of non-financial corporations in the euro area 35 2.2 Eurosystem balance sheet dynamics towards the end of net asset purchases 38 2.3 The risk management framework for the APP mitigates financial risks, while supporting the monetary policy objective 41 3 Euro area financial sector: increasing bank resilience amid risks 46 3.1 The financial stability environment in 2018 46 3.2 The ECB’s macroprudential policy function 49 3.3 Microprudential activities to ensure the soundness of individual banks 52 Box 4 The 2018 EU-wide bank stress test 53 3.4 The ECB’s contribution to strengthening the banking union and the capital markets union 56 ECB Annual Report 2018 1 4 Smooth functioning of market infrastructure and payments 58 4.1 TARGET Services 58 4.2 Maintaining the safety and efficiency of financial infrastructure throughout the digital transformation process 59 5 Efforts to support market functioning, and financial services provided to other institutions 62 5.1 The €STR, the new overnight reference rate for euro area money markets 62 5.2 Administration of borrowing and lending operations 65 5.3 Eurosystem Reserve Management Services 66 Box 5 FX Global Code 67 6 More banknotes, less counterfeits 69 6.1 Steady increase in banknote circulation 69 Box 6 Eurosystem survey on cash services offered by credit institutions and the acceptance of cash payments by retailers 70 6.2 Euro banknote counterfeiting remained low and declined further 76 6.3 €100 and €200 banknotes with enhanced security features unveiled 77 7 Statistics 79 7.1 New and enhanced euro area statistics 79 Box 7 A collaborative approach to ESCB statistics 80 7.2 Enhanced transparency and communication 82 Box 8 20 years of ESCB statistics: What’s next? 83 8 ECB research priorities 85 8.1 Activities of the ESCB research clusters and the PRISMA project 85 8.2 Conferences and publications 87 9 Legal activities and duties 88 9.1 Jurisdiction of the Court of Justice of the European Union concerning the ECB 88 9.2 ECB opinions and cases of non-compliance 89 ECB Annual Report 2018 2 9.3 Compliance with the prohibition of monetary financing and privileged access 93 10 Key issues on the European and international agenda 95 10.1 Deepening EMU 95 10.2 Discharging accountability 96 10.3 Implications of Brexit 97 10.4 International relations 98 11 Enhancing communication 101 12 Good governance, organisational excellence, resilience and environmental performance 104 12.1 Unlocking excellence through diversity and inclusion 104 12.2 Strengthening integrity and governance standards 105 12.3 Cyber resilience 106 12.4 Reducing the ECB’s ecological footprint 109 Annual Accounts A1 Consolidated balance sheet of the Eurosystem as at 31 December 2018 C1 Statistical section S1 ECB Annual Report 2018 3 The year at a glance While the economic expansion in the euro area continued in 2018, the economy experienced a loss of growth momentum. Growth decelerated from 2.5% in 2017 to 1.8% in 2018 as a series of headwinds emerged over the course of the year. A significant weakening of world trade, coupled with a number of country and sector-specific factors, weighed on the external sector and manufacturing in particular. The domestic economy nonetheless remained relatively resilient, buoyed by a continuing recovery in the labour market. Employment has increased by 10 million people since the trough in mid-2013 and the unemployment rate fell to 7.8% in December, the lowest rate since October 2008. Strong labour market dynamics translated into steady and broad-based wage growth, which reached 2.2% in the last quarter. Rising employment and wages in turn helped underpin consumer spending. Headline inflation increased relative to the previous year, averaging 1.7% over 2018, although this mostly reflected higher energy prices. Measures of underlying inflation moved broadly sideways throughout the year. However, the outlook for domestic demand, the labour market and wage growth gave us confidence that inflation would continue to converge towards our objective over the medium term. As a result, the Governing Council anticipated in June 2018 reducing the monthly pace of net purchases under the asset purchase programme (APP) to €15 billion from September and – subject to incoming data confirming its medium-term inflation outlook – ending net purchases in December. At the same time, the Governing Council communicated that it expected the key ECB interest rates to remain at their present levels at least through the summer of 20191 and in any case for as long as necessary to ensure that the evolution of inflation remained aligned with expectations of a sustained adjustment path. In December, the Governing Council reviewed the economic outlook and concluded that the June assessment remained broadly accurate. On that basis, it ended net asset purchases under the APP and confirmed the enhanced forward guidance on the path of interest rates. In parallel, it confirmed the need for continued significant monetary policy stimulus to support the further build-up of domestic price pressures and headline inflation developments over the medium term. That stimulus would be provided by forward guidance on key interest rates, reinforced by reinvestments of the maturing principal payments of the sizeable stock of assets acquired under the APP. The Governing Council conveyed that such reinvestments would continue for an extended period of time past the date when key interest rates rise, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation. 1 In March 2019 the Governing Council communicated that it now expected key interest rates to remain at their present levels at least through the end of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term. ECB Annual Report 2018 4 The Governing Council also confirmed that, in any event, it stood ready to adjust all of its instruments, as appropriate, to ensure that inflation continued to move towards our aim in a sustained manner. The continued domestic recovery and micro- and macroprudential actions also helped support financial sector resilience in 2018. The aggregate Common Equity Tier 1 ratio of significant institutions reached 14.2% at the end of the third quarter of 2018. Outstanding non-performing loans (NPLs) declined by €94 billion in the first three quarters of 2018, and euro area significant institutions’ aggregate NPL ratio stood at 4.2%, down from 5.2% a year earlier. Risk-taking in parts of the financial and real estate markets contributed to mild signs of overstretched valuations in some areas, with marked cross-country differences, while risks continued to grow in the non-bank financial sector. In this environment, macroprudential measures were implemented in euro area countries to mitigate systemic risks: during 2018 the ECB assessed 103 notifications of macroprudential policy decisions by national authorities. The ECB continued to support the benchmark reform in the euro area, developing a new money market reference rate during 2018. The ECB published the methodology for the euro short-term rate (€STR) in June 2018 after it received broad support in two public consultations. The €STR is based on average daily volumes of approximately €32 billion as traded by around 32 banks. The private sector working group on euro risk-free rates recommended the €STR as the replacement for EONIA in September 2018. The €STR will be available in October 2019, following a period of thorough internal testing by the Eurosystem. 2018 also marked a significant step forward in euro payments. In November, the Eurosystem launched the TARGET Instant Payment Settlement (TIPS) service, which offers instant payments around the clock in less than ten seconds. As shown by the December Eurobarometer, support for the euro in 2018 rose to 75%. The ECB continued its efforts to connect with euro area citizens and to improve its accountability and transparency by engaging with the European Parliament, but also by expanding our “Youth Dialogues” and by fostering the use of our website, social media and Visitor Centre. Turning to the coming year, substantial monetary policy stimulus remains essential to ensure the continued build-up of domestic price pressures over the medium term. In view of the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets, the conduct of monetary policy in the euro area will continue to require patience, prudence and persistence. Frankfurt am Main, April 2019 Mario Draghi President ECB Annual Report 2018 5 The year in figures Euro area real GDP growth Increase of headline inflation in moderated in 2018 2018 1.8% 1.7% Euro area output continued to expand Average headline inflation in the euro in 2018, albeit at a slower pace than area increased further, in 2017.