ECB optimistic but alert about risks to financial stability

(Bloomberg) – The European Central Bank is relatively optimistic about the economic outlook, as it prepares for a crucial monetary policy meeting next month, despite mounting risks to financial stability from overvalued asset prices.

The risks to the economic outlook “are much more balanced than in the past,” said Luis de Guindos, vice president of the ECB, in an interview with Bloomberg Television. “Vaccines are gaining momentum in all parts of Europe, and we are catching up, we are closing the gap.”

The ECB’s Governing Council will meet on June 10 to review the updated projections and judge whether it should start to reduce its emergency bond purchase program. Purchases intensified this quarter to offset rising borrowing costs driven by a faster recovery in the United States.

Guindos said that policymakers will take into account a wide range of uncertainties, including new variants of the virus and risks for some emerging markets. He also noted the growing risks addressed in the ECB’s Financial Stability Review, released on Wednesday.

That report commented on the dangers of high debt burdens and “extraordinary exuberance” in the markets, language that echoes former Federal Reserve Chairman Alan Greenspan’s comment on “irrational exuberance” during the dotcom bubble in the US. 1990s.

There is concern that the avalanche of fiscal and monetary stimuli needed to combat the crisis also accumulates dangerous imbalances. Guindos says the ECB sees “some overvaluation segments,” but there is no asset bubble so far.

Nonetheless, the ECB warned that if more upward surprises in US inflation prompt investors to tighten monetary early, which would raise bond yields without a complementary improvement in economic growth, ” the spill-over effects of the revaluation of the US equity market could be substantial. “

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Rising yields would depress bond prices and weaken the balance sheets of the region’s banks, which have long suffered weak performance.

“Therefore, a 10% correction in the US stock markets could lead to a significant adjustment of the financial conditions of the eurozone, similar to about a third of the adjustment observed after the impact of the coronavirus in March of 2020, ”he said.

While the Fed has rejected suggestions of an imminent adjustment, some investors are betting that it will have to cut support as soon as possible. US consumer prices rose in April to the highest since 2009, prompting officials to insist such increases are likely to be transitory.

In the long term, Guindos said the ECB will not avoid withdrawing support once the pandemic crisis has passed.

The ECB report also noted “exuberance” in crypto assets, stating that “the rise in bitcoin has overshadowed previous financial bubbles.” Still, it concluded that since such assets are not widely used for payment, and banks have limited exposure, financial stability risks “appear limited at present.”

The central bank highlighted other risks facing the economy, including weakness in the labor market and subdued investment that could lead to a slow recovery. It also included a new analysis of climate-related risks, which affect a “significant proportion” of bank loans to businesses.

The ECB said the uneven economic impact of the pandemic means financial stability risks are likely to materialize in sectors and countries with higher pre-existing vulnerabilities.

Original Note: ECB’s Guindos Upbeat on Economy Despite Financial Stability Risk

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