The outlook for the euro area remains highly uncertain, shaped by tighter financing conditions, heightened geopolitical tensions, and significant rising risks, such as climate and cyber risks, Governor of the Central Bank (CBC) of Cyprus, Christodoulos Patsalides, said at the Economist 20th Annual Cyprus Summit, adding that Europe is falling behind with much lower productivity levels compared to the United States and worrying that if trade restrictions materialise, the outcome may be "inflationary, recessionary, or worse, stagflationary."

Patsalides repeated, however, that ECB's approach on monetary policy continues to be gradual and data-driven and if incoming data and new projections in December “confirm our baseline scenario”, there will be room to continue lowering rates at a steady pace and magnitude.

The CBC Governor, in his address, noted that, striking the right balance is essential, as overly aggressive rate cuts could risk reigniting inflationary pressures, while cutting rates too slowly might unnecessarily hinder economic recovery and dampen market confidence.

He referred to the current discussion on interest rates, noting that the Governing Council of the ECB, at its meeting in October, advanced its policy easing “as our assessment of the latest data confirmed significant progress in the disinflationary process, with inflation in October standing at 2%”. Going forward, the pace and magnitude of further rate cuts remain a subject of ongoing assessment, he added.  

“While growth in the euro-area economy has been anaemic for some time now, the approach to rate cuts must be gradual and data-driven”, he said, adding that, inflationary pressures, particularly those stemming from potential supply shocks, “still pose risks.”

“There is still considerable uncertainty with regards to energy prices and services inflation continues to be sticky at 4%. Moreover, trade tensions are rising. If trade restrictions materialise, the outcome may be inflationary, recessionary, or worse, stagflationary”, Patsalides noted.

“If incoming data and new projections in December confirm our baseline scenario”, he noted, there will be room to continue lowering rates at a steady pace and magnitude. In general, he added, “striking the right balance is essential, as overly aggressive rate cuts could risk reigniting inflationary pressures, while cutting rates too slowly might unnecessarily hinder economic recovery and dampen market confidence”. At this juncture, the Governor said, monetary policy is “a balancing act”, and these considerations confirm that maintaining optionality without any predefined path “is the prudent avenue for our policy calibration”.

Referring to the European banking sector, which, he said, in recent years, “has shown remarkable resilience” despite facing significant economic and geopolitical turmoil, noted that the latest key indicators of June 2024, support the aforementioned with the liquidity ratio reaching 163.2%, the CET1 ratio increasing to 17.5% and the Non-Performing Loans ratio remaining relatively steady at 1.9%. “It is fair to say that the Single Supervisory Mechanism, celebrating this year its 10-year anniversary, is delivering exceptional outcomes”, he added.

However, Patsalides said, the outlook for the euro area remains highly uncertain, shaped by tighter financing conditions, heightened geopolitical tensions, and significant rising risks, such as climate and cyber risks. Both the SSM and the European Banking Authority have incorporated these risks into their supervisory and regulatory priorities, he noted, adding that banks are required to align their practices with the relevant guidelines and take the necessary steps to incorporate these risks in their business models. The ECB's strategy for the next three years is focused on addressing these challenges effectively, the Governor said.

“Yet, as is, the banking sector alone cannot drive the transformative changes needed in the European economic landscape. The pursuit of a stronger and more competitive European economy requires the establishment of a truly integrated Capital Markets Union and the completion of the banking union with the introduction of a common deposit guarantee scheme”, he said. “The alarming reality is that Europe is falling behind with much lower productivity levels compared to the United States”, he said. This challenge is further intensified by growing competition from other economies like China, he said, adding that this requires bold structural reforms to effectively channel savings into productive and innovative private investments. 

According to Patsalides, the Draghi Report “provides the right recipes” to achieve these goals. It also sheds light on key weaknesses in the European economy and offers actionable guidance, he said, noting that at the EU level, deeper capital markets and financial integration will close the innovation gap, particularly by strengthening the European venture capital market, which significantly lacks behind that of the US.

“In fact, the Financial Stability Review of the ECB published yesterday, shows that the US venture capital market is five times larger than that of the euro area”, he pointed out, adding that diversifying financing options for European firms, beyond traditional bank lending, is also crucial. Encouraging IPOs and equity investments for start-ups and scale-ups can be achieved by reducing regulatory barriers, especially in advanced digital technologies. Additionally, having a single supervisor for EU capital markets would ensure consistent risk treatment, reduce fragmentation, and boost confidence in EU capital markets—key steps toward realizing a unified capital market, he said.

Frank Elderson, member of the executive board of the European Central Bank, said that ECB, to counter inflation began in July 2022 increasing its key interest rates at an unprecedented pace. By September 2023, they had risen by 450 basis points in total with the deposit facility rate reaching 4%. Since then, the incoming information has shown that the disinflationary process is ongoing, allowing ECB to steadily reduce rates by 75 basis points since June of this year, with the deposit facility rate now sitting at 3.25%.

“Throughout this adjustment to interest rates that are still higher than before the pandemic, the European economy has demonstrated its resilience, which is built on the reforms that have been implemented since the global financial crisis and the European debt crisis”, he said.

Despite this positive progress, Elderson warned that the economy has by no means escaped the treacherous waters of recent years. “We are venturing into uncharted territory. In addition to risks to the outlook for economic activity being tilted to the downside, structural trends are developing that will provide significant challenges to the global and European economies in the years to come”, he said, mentioning geopolitical tensions, fragmentation and protectionist tendencies, along with the climate crisis, that leads to bottlenecks that impose interruptions and damages to the productive capacity.

“For monetary policy, this challenging environment implies that we must remain laser-focused on our price stability objective”, he noted, adding that monetary policy may have to respond more protectively to shocks than has been considered appropriate in the past. At the same time, he added, assessing the appropriate monetary policy response becomes more complicated. Therefore, the flexibility and data dependency applied in navigating the challenges of the past few years will remain crucial for years to come.

Jose Manuel Campa, Chairperson of the European Banking Authority, said, via teleconference connection, that “we have built over the last 15 years, an institutional framework that has proven to be resilient, that has proven to build better and stronger banks” but it was necessary to make sure “that we finish the Banking Package that we have put in place in the EU, so we have a robust regulatory system” and continue to have a banking sector “that would help us as we go forward with the challenges ahead”.

The two challenges faced, he also said, were digitalisation and climate change. “We need to make sure that we continue to push on the aspects necessary to enhance our ability to properly assess the financial risk arising from those challenges, both in terms of transition risks, physical risk and long-term sustainability”, he said.