Why the ECB should still be worried about wages

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European Central Bank president Christine Lagarde spurred investors to ramp up bets on early rate cuts this week by saying wage growth was showing signs of cooling, causing the euro and bond yields to fall. But economists warn that rate-setters still want hard data to confirm the impact on inflation before they take action.

The big fear for all central banks since the start of the inflation surge has been that workers’ demands for higher pay to maintain their living standards would fuel persistent price rises. 

Wages were slower to rise in the EU than in the US or UK, because so many workers are covered by sectoral pay deals that last several years and take time to renegotiate.

But by the third quarter of last year the effect was clear: the ECB’s real-time tracker of negotiated wages showed that annual pay growth hit 4.7 per cent, the fastest pace in the history of the single currency area. That compares with annual wage growth of 4.1 per cent in the US and 6.5 per cent in the UK, according to the latest data.

Lagarde said at the ECB’s press conference on Thursday that the pay of 40 per cent of employees covered by its wage tracker was “yet to be determined” because it was covered by collective agreements expiring in December and the first quarter of 2024. 

This means the ECB will receive crucial information in the next few months on the extent of underlying inflationary pressures. 

Lagarde’s comments suggested the ECB is cautiously optimistic about a benign scenario where wages grow more slowly, at a pace that allows workers to repair their living standards, while companies take a hit to profits rather than passing the cost to consumers. 

The central bank’s in-house wage tracker suggests pay growth has stabilised in recent weeks as job vacancies have declined, Lagarde said. “We are seeing a slight decline, so it is directionally good from our point of view.”

Wage growth is expected to slow from about 5.3 per cent last year to 4.4 per cent this year, according to an ECB survey of 70 non-financial companies published on Friday, which found “an increasing number” were planning to cut jobs. The bank has said 3 per cent wage growth is consistent with inflation in line with its 2 per cent target.

Meanwhile the ECB’s assumption that wage increases would be absorbed in companies’ margins was “exactly what we have seen”, Lagarde said, adding: “There is a phenomenon of catching up for employees. It’s also one of the reasons why we see growth coming up and the recovery beginning in the course of 2024, because of rising wages while inflation comes down.”

“I’m not worried about what I see in wages,” an ECB governing council member told the Financial Times after Thursday’s meeting, when the central bank held rates at a record high of 4 per cent. “But we don’t need to rush, we need to be cautious and make a judgment based on data that will be coming out.”

Policymakers have expressed differing views on how important quarterly wage growth figures will be when deciding when to cut interest rates.

Data on first-quarter eurozone wage growth will be published shortly after the ECB’s meeting in April, suggesting its June vote may be the earliest rates could feasibly be cut. Philip Lane, ECB chief economist, seemed to signal this by saying recently: “By our June meeting, we will have those important data.”

However, Lagarde downplayed the need to wait for the first-quarter wage figures to be confident that inflation had been tamed. “We look at a whole range of data, we are not only focused on wages,” she said. “So I would not draw any conclusion from a date of publication.”

As well as tracking wage developments in real time, policymakers will be keeping a close watch on company profits, service sector inflation, constantly evolving energy prices and fiscal decisions on the withdrawal of support for household energy bills, Lagarde noted. 

However, economists said that given how much emphasis the ECB has put on the importance of wages, its rate-setters were likely to want to see the quarterly data before being confident enough to loosen policy.

“They are clearly warming up to a rate cut,” said Dirk Schumacher, a former ECB economist now at French bank Natixis. “The market is pricing in a cut in April, but the ECB won’t have the wage data they want by then, so I think the economy really needs to tank for them to cut before June.”

There are still signs that unions are pushing for big pay rises, including a demand in Germany for a €500-per-month wage increase for the country’s almost 1mn construction workers. That is equivalent to an eye-catching 21 per cent pay rise for the sector’s lowest-paid majority, although German unions often accept about half what they ask for.

There is also a lingering concern that companies are hoarding labour. Unemployment hit a record low of 6.4 per cent across the bloc in November despite the weak economic backdrop. But average working hours have fallen, potentially because companies are reluctant to lay off staff who will be hard to recruit when demand picks up.

There are also widespread indications the eurozone still has significant labour shortages and mounting wage pressures. A near-record 31 per cent of services companies complained of worker shortages in a recent EU survey. Companies are also passing on rising labour costs via their sharpest price increases for many months, according to an S&P Global poll.

“Negotiated wages have yet to decisively turn, while labour productivity is persistently weak,” said Hugo Le Damanay, economist at Axa Investment Managers. 

All this means the ECB will have to remain cautious. Despite her more dovish remarks on Thursday, Lagarde showed an awareness of this, saying: “We need to be further along the disinflation process before we can be sufficiently confident that inflation will actually hit the target in a timely manner.”