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Economy

Opportunities and risks for the European economy in 2018

2017 has been good, but normalizing monetary policy now takes center stage

The most important policy area that will deserve careful deliberation and cautious action is monetary policy.   © AP

As 2017 draws to a close, it is a good moment to review the main risks for the upcoming year and explore some of the opportunities.

Let us start with the opportunities: 2017 has been a good year for the global and the European economy. GDP growth numbers have been revised upwards in Europe with the notable exception of the United Kingdom. Unemployment has been falling rapidly while employment is at an exceptionally high level.

2018 could very well bring a continuation of that positive story. Balance sheets of banks and corporations are stronger than a year ago. Banks have made progress with addressing their non-performing loan portfolios, even though a lot of work remains to be done. Corporate debt to GDP ratios have been falling.

Meanwhile, fiscal deficits have also fallen so that the need for austerity is receding. France has enacted some important labor market reforms that should help with the labor market, and Italy should benefit from the labor market reforms enacted in 2015.

Monetary policy key

Yet, there are important risks. The most important policy area that will deserve careful deliberation and cautious action is monetary policy. As the global financial crisis unfolded, the European Central Bank and other central banks greatly extended their monetary policy toolboxes and adjusted their operational frameworks.

The main characteristic of monetary policy in recent years is that the primary instrument -- the interest rate -- has been at the zero lower bound and has de facto become ineffective. This has lead the ECB to follow in the footsteps of the U.S. Federal Reserve and use other ways to implement monetary policy.

These so-called unconventional monetary policies have left central banks with large balance sheets. In fact, the various measures of the ECB have resulted in the quadrupling of the size the ECB's balance sheet to above 4 trillion euros. More than 2 trillion euros resulted from the government bond purchase program.

As growth picks up in the euro area, the discussions on when and how to normalize monetary policy will accelerate. One important question is whether to first normalize interest rates, i.e., increase the main interest rate, and then to phase out government bond purchases or the other way around.

Overall, European policy makers seem to prefer to first phase out bond purchases and only then move the short-term interest rate. As a result, the yield curve could first steepen before it may gradually shift upwards. This sequencing of the normalization process would correspond to that of the U.S. Fed, which started with tapering, i.e., gradually reducing asset purchases, then increasing key policy rates slowly before reducing passively the size of the balance sheet.

The debate on the optimal size of the central bank's balance sheet has not yet been settled. It is a question of fundamental importance on whether and how quickly to reduce the balance sheet size of the ECB and absorb the large amounts of liquidity in the markets.

If liquidity is removed too quickly, long-term interest rates and asset prices may react drastically. This could result in substantial financial instability. In my view, the ECB should therefore only gradually reduce its balance sheet size. But even then, financial stability risks may be the most important thing to watch next year.

There are other risks: A number of elections, most notably in Italy, may change the political landscape in Europe substantially. Progress has been made on avoiding a cliff-edge Brexit, but the political situation remains highly unstable and could still undermine a smooth progress towards a close trade agreement.

Meanwhile, Germany still has no government and any broader debate on how to shape the future of Europe's monetary union is therefore on hold. So overall, we are looking at another exciting year ahead.

Guntram Wolff is director of Bruegel, a think tank based in Brussels.

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