The wage conundrum

• The euro area labour market is less tight than in the US and UK, but labour demand has picked up noticeably with the recovery from the pandemic.

• In light of unions’ improved bargaining position and real income security as the prime focus for this year’s bargaining rounds, we expect negotiated wage growth to pick up to rates of 3-3.5% in late-2022/2023. That should allow ECB to continue on its path of gradual policy normalisation.

The chicken and the egg: Wages and core inflation

While upside risks from commodity price movements dominate the near-term outlook for euro inflation, wage developments will have important implications how durable inflation pressures will remain in 2023 and beyond, when negative base effects from high food and energy prices will likely again start to weigh on headline inflation. This will also have important repercussions on the pace and degree of policy tightening enacted by the ECB. With wages being a crucial cost item, especially for services firms, there has historically existed a close link between wage growth and core inflation. Usually, rising wage growth has filtered through to core inflation with a six to twelve month lag in the euro area. However, rising wages are a necessary, but not sufficient condition for a sustained rise in core inflation. What ultimately matters for inflation is wage increases relative to productivity growth (i.e. unit labour costs) and unless wage growth accelerates more than two percentage points beyond productivity growth in a sustained manner, inflationary pressures will remain contained. This view is also shared by the ECB, with wage growth of around 3% (1% average productivity growth plus 2% inflation) seen as consistent with achieving price stability.

So far euro area wage growth has remained muted, with negotiated wages growing by a meagre 1.6% in Q4 21. Wage growth measured by compensation per employee was slightly higher at 3.5% at the end of 2021, but annual growth rates remain distorted by the impact of furlough schemes (in which some 1.7mio workers are still enrolled in Germany, Italy and France). The lack of imminent wage pressure is one reason why the ECB is pursuing a more gradual policy normalisation pace than e.g. the Fed, but inflation rates well above target throughout the rest of the year raise the risk of higher inflation expectations fuelling wage adjustments down the line.

To assess the outlook for wages, a good starting point is taking a closer look at the euro area labour market, which staged a strong rebound from the pandemic. The unemployment rate fell to a new all-time low of 6.8% in January and we expect this benign dynamic to continue in 2022, despite the Ukraine war (although furlough schemes might be used to a greater extend in some affected manufacturing sectors). However, compared to the US the euro area labour market remains less tight, when looking for example at the number of unfilled vacancies and country differences also persist, with reports of labour shortages most prominent in Germany. A broader analysis of labour market conditions also points to the existence of more slack than hits the eye just by looking at the unemployment rate. While GDP and total employment have returned to pre-pandemic levels, total hours worked still stood ca. 2% below the level of end-2021.

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