Wage Pressure and Inflation in the Eurozone: Are Labor Costs the Key to Interest Rate Cuts?

Note: This is an abridged and translated version of an original article (in German), which has been posted on the website of Helaba Invest Kapitalanlagegesellschaft mbH . For the full version, please visit www.helaba-invest.de

“Hey Boss, I need more money!” – echoing a popular German song from the 1970s, many employees and unions in the Eurozone are currently demanding significant wage increases. This trend, which has gained momentum since 2022, has also caught the eye of the European Central Bank (ECB). While progress has been made in headline and core inflation, the especially stubborn rate in the labor-intensive services sector remains a concern. Indeed, uncertainty about wage developments has likely contributed to the delay of discussions on potential rate cuts, with the ECB now finally zeroing in on June for their first move.

However, due to poor data availability, the ECB's heightened focus on wage pressure is at least debatable. Official aggregate wage indicators for the Eurozone are published only quarterly and often with significant delays, making the timing of monetary policy decisions even more difficult. Moreover, in the current environment of weak demand and below-average capacity utilization, it is even unclear whether higher wages contribute significantly to inflation. As can be seen in Figure 1, employees have suffered substantial real wage losses due to recent crises, which continue to burden private consumption. Compared to pre-pandemic levels, labor as an input factor is still relatively cheap.

In sum, there are two key questions for monetary policy:

1. What explains current wage developments? Are labor costs still driven by significant catch-up effects due to previous supply shocks, or have other factors, like an acute shortage of skilled labor, already taken the wheel?
2. Could persistently high wage growth jeopardize the central bank’s inflation target?

The Helaba Invest Labor Cost Index

Our preferred measure of wage pressures in the Euro Area is the Helaba Invest Labor Cost Index (HAI). This proprietary index is based on labor costs per hour published by the European Commission but enriched with additional data from the national statistical institutes as well as alternative sources, such as Google Trends or Indeed. Consequently, our indicator can be calculated for the first time in the middle of each month and becomes more accurate with each additional data point. Another advantage is that the HAI considers taxes (subsidies) and other levies that may further increase (decrease) the cost of labor from a business perspective. Unlike other available indicators, the HAI directly links higher wages and cost pressures.

As can be seen in Figure 2, there were already signs of a trend reversal in labor costs in the Eurozone by mid-2021. Over the following months, the growth rate of our index accelerated, reaching a preliminary peak of 6.2% in March 2023. Recently, labor cost pressure has decreased to a rate of 4.5%.

Macro Shocks as Drivers of Labor Costs

To get a better understanding of this development, we decompose labor cost inflation into its short- and medium-term drivers using a structural vector autoregressive model (SVAR). By means of a Cholesky decomposition, we identify six different macroeconomic shocks that can potentially explain the deviations of the variables from their structural mean: Regarding the supply side, we consider the state of global supply chains and possible disruptions in energy prices. On the demand side, we differentiate between the general state of the business cycle and an independent additional labor demand, which can be explained, for example, by hoarding of skilled labor. Finally, there are two “Other” types of shocks: fluctuations in consumer price inflation not explained by the previous four influences, such as changes in inflation expectations, as well as independent fluctuations in labor costs, for example due to tax adjustments or subsidies.

As illustrated by Figure 2, our model explains the short- and medium-term labor cost fluctuations quite well. We find that pandemic-related supply chain disruptions and energy price shocks have played considerable roles during the recent surge, together contributing up to 77% of the increase in labor costs. Overall, the rise since 2022 is overwhelmingly due to catch-up effects in response to the crisis-related supply shocks. Except for labor hoarding, other factors have hardly played any role. Therefore, with the closing of the real income gap shown in Figure 1, wage pressures should also normalize in the future.

Indeed, the SVAR predicts a continuous decline in labor cost pressure to about 3.2% by March 2025, largely thanks to the ebbing of the supply-side influences. The projected path of the HAI is clearly below what would be considered consistent with the sideways projections by the ECB, for instance. However, our model still does not foresee a complete normalization of cost pressures: both a lagging influence of the business cycle and persistent effects of labor hoarding are expected to keep labor cost inflation above its long-term trend until 2025.

From Wages to Prices

Even if labor costs continue to increase, a wage-price spiral in today’s Euro area is much less likely than it was during the 1970s, for example. Various surveys show that medium-term inflation expectations in the Eurozone have risen but are far from being truly unanchored. After initially misjudging the rise in inflation as a “transitory” phenomenon, the ECB obviously managed to avoid a deeper reputational damage by the subsequent rate hikes at record speed. Furthermore, there is hardly any automatic translation from higher wages to prices as there was during the 1970s. While nearly 60% of economic activity was still associated with inflation-indexed collective agreements back then, today this is down to 3% (Figure 3). Therefore, the importance of wages for general price formation has significantly decreased over the past decades.

A similar result is obtained when we decompose consumer price inflation into its macroeconomic drivers. Figure 4 shows a pattern where supply-side shocks again stand out. It is notable that independent fluctuations in labor costs have hardly any impact on overall inflation. Furthermore, consumer prices appear to lead wage pressure by several months. In the context of our model, labor costs generally appear as lagging and significantly influenced by shocks in other variables.

In the upcoming months, the behavior of companies will be decisive. There have been signs that firms have used the exceptional circumstances of the past years to pass on the rising costs of energy and intermediate goods to consumers to an unusual extent – see, e.g., Lane (2023) or Hansen et al. (2023). There are thus now two levers through which further significant price increases could be avoided: falling producer prices reduce overall company costs, and the underutilization of the economy, which is expected to persist until the second half of the year, could lead to more competition and lower profit margins.

Against this backdrop, the SVAR predicts a continued decline in consumer price inflation for the rest of the year. While much of the disinflationary impulse from the supply side is already behind us, the two relevant components should nonetheless continue to dampen Eurozone inflation. Combined with a relatively weak overall demand, this could lead to a temporary drop in the inflation rate below the ECB’s target in the third quarter. However, a continued positive influence of labor hoarding may cause inflation to stabilize around two percent afterwards.

In the appendix to the original article we discuss some robustness checks for our approach, including the potential impact of recent labor supply and productivity developments. We also compare our results to other recent studies.

Conclusion and Investment Implications

We find that the recent rise in labor costs is mainly due to catch-up effects following past supply shocks. Pandemic-related disruptions and the energy crisis have first driven up prices and then wage demands. As these effects now fade, labor cost pressures should also normalize. Our econometric model predicts a significant decline in labor cost inflation from the current 4.5% to 3.2% by March 2025.

However, even if wage growth remains high, that does not necessarily mean that the ECB will miss its inflation target. With the disappearance of indexed wages since the 1970s, the importance of labor costs in general price formation has also decreased. Moreover, companies can potentially offset rising labor costs with high recent profits and now falling costs for energy and intermediate goods. Overall, we expect further disinflation during the upcoming months and a subsequent stabilization of the headline rate around the ECB’s target.

Given our findings, the current emphasis on wage pressure by central bankers and economists may be misplaced. There is clearly a risk of focusing too much on a variable that lags behind general macroeconomic developments. Only the trend towards labor hoarding deserves continued attention, as a less-cyclical labor demand seems to be establishing itself due to a shortage of skilled workers. Apart from that, geopolitical factors remain the most important risk to the inflation outlook. If things remain calm on this front, there should be little in the way of a first rate cut by the ECB in June. We expect a total of three rate cuts by the end of 2024 and further cuts in 2025. For long-term oriented investors, the recent increase in Euro area bond yields could therefore represent a worthwhile point of entry.