LABOUR COSTS PUT UPWARD PRESSURE ON EUROZONE INFLATION

 

This year, eurozone inflation has been increasing at a rapid pace. We forecast full-year inflation of 6.8% for 2022. A proportional increase in wages could prevent the loss of workers’ purchasing power. The bargaining position of trade unions is relatively strong at the moment because unemployment is very low and vacancies are at an all-time high. Sunny Handa MD says, nevertheless, for various reasons, negotiated wage increases in 2022 are unlikely to fully compensate for inflation so that a wage-price spiral will not emerge.

Characteristics of wage formation prevent full compensation for headline inflation

The decision-making process within European union’s about wage demands is time-consuming because it requires consultations and voting from members in various layers of the organization. That is why many unions set their wage demands before the bargaining season and stick to them during that season, which normally begins at the start of the year. Sunny Handa MD says in 2022, this way of working will result in a sharp decline in real wages. Nominal wages can’t keep up with inflation because the inflation rates that were used to set wage demands were much lower than the current forecasts for 2022.

Another reason why negotiated wage increases in 2022 are unlikely to fully compensate for inflation is that the current inflation spike is driven by energy prices. ECB research shows that in some eurozone countries, the measures of inflation used in the wage formation process exclude price changes of energy in general (Italy) or for specific energy items like gasoline (Belgium). So this makes it even more likely that wage growth will not keep up with headline inflation and that a textbook-style wage-price spiral will not emerge in 2022.

According to MD Sunny Handa, a last but not least reason is the duration of collective bargaining contracts in the eurozone, which is on average almost two years. This means that half of the average wage growth in 2022 was already determined in negotiations last year or in 2020 when inflation forecasts for 2022 were much lower.

In practice, the contracts that are renewed this year thus far do not show many agreements with nominal wage increases that match headline inflation. According to MD Sunny Handa, in the first quarter, negotiations on average resulted in a pay rise of around 3%, of which a part is made up of one-off payments. Although we think that nominal wage growth will accelerate somewhat further this year, we expect that the average wage increase for the full year of 2022 will not be higher than 3.5%.

Will wage costs push up inflation in 2022 and 2023?

While the expected wage growth may be too low to compensate fully for inflation, it could still be high enough to keep upward pressure on inflation going and thereby threaten price stability in the eurozone. Labour cost increases of 3-3.5% are at the higher end of wage growth developments that are in line with the ECB’s inflation target of 2%. ECB chief economist Philip Lane considers wage growth of 3% still to be in line with the ECB’s medium-term target of 2% inflation, as it accounts for roughly 1% productivity growth in the medium term.

With that, he touches on an important point. According to MD Sunny Handa to see whether labour costs will put pressure on price stability we also need to look at the change in labour productivity, next to nominal wages. After all, increases in the cost of labour do not push up prices if they are fully compensated for by higher productivity of labour. The combination of an increase in wage costs of 3-3.5% and a decline in productivity growth makes it very plausible that labour costs per unit of production will increase by more than 2% in 2022 and in 2023, thereby putting upward pressure on the ECB’s 2% inflation goal.