Stars align for rebound in eurozone wage growth

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By Bert Colijn, Carsten Brzeski

Everyone in Frankfurt and beyond is watching the labor market to see if the second-round effects of the current inflationary shock are already visible in the data. We, and the European Central Bank (ECB), see no evidence of this so far, as the ECB’s Negotiated Wage Index actually hit its lowest wage growth figure in decades in 3Q21 (1.3% YoY). If the labor market is a lagging indicator, however, wage developments are the mother of all lagging indicators. Looking ahead, we expect wage growth to pick up significantly in 2022 and 2023 to around 3.5%, with the main drivers of wage growth signaling strong increases.

Labor shortages continue to grow

The last few months have seen a surprisingly rapid decline in unemployment and the economy has recovered faster than expected, leading to a stronger than expected rebound in the labor market. Leave schemes – key to keeping unemployment relatively low in 2020 – saw a sharp drop in participation in 2021, even as global supply chain frictions led to renewed demand for leave schemes in manufacturing . A significant increase in structural unemployment has fortunately not materialized, and we now expect unemployment to continue its downward trend over the coming year as employers’ expectations for hiring remain very strong for the start of 2022.

Late last year, we wrote in depth about emerging labor shortages, and since then new data shows the labor market has tightened further. Vacancy rates are now higher than before the pandemic, while companies have already indicated that the availability of labor has never been more problematic for their production than it is now. In the euro area, there are still fewer people in the labor force than before the crisis, which means that there is still some slack on the fringes of the labor market which could help alleviate these problems to some extent – unless people leave the labor force permanently. Either way, it looks like labor shortages are set to remain a dominant economic theme in 2022.

The relationship between wage growth and unemployment has weakened over the past decade, fueling debate over whether the relationship between unemployment and inflation – the Phillips curve – is dead. It seems that the relationship between unemployment and wage growth is still alive, at least, but with a year lag and flatter than before. Simply put: it takes longer for wage growth to emerge from low unemployment, and it also leads to lower wage growth. It is important to note that the last decade has been marked by poor employment development and slight shortages. Now that labor market tightness has become more pressing, it seems logical that this would once again have a bigger impact on wage growth. Let’s go back to 2019, for example, when shortages also led to a slight acceleration in wage growth, which was halted by the pandemic. It is possible that with labor shortages returning to pre-pandemic levels, wage growth will pick up where it left off in 2019.

The Phillips curve has flattened over the past decade

The Phillips curve has flattened over the past decade in the euro area.

Eurozone Phillips Curve

Eurostat, ECB, ING Research

Inflation strengthens union demands

It’s not just labor shortages that point to higher wage growth. Inflation is another key driver of wage growth in the Eurozone, especially since wage setting in the Eurozone is done mainly through collective bargaining and inflation is an important input used in these negotiations. Purchasing power is currently squeezed by inflation at its highest level since the 1980s, and wages negotiated in the Eurozone have historically tracked inflation closely.

In some countries, such as Belgium and France for example, inflation has a direct impact on wage growth via indexation. Other countries are seeing inflation come through higher union demands which, in turn, result in better bargaining outcomes for workers. In the past, unions have used either actual inflation rates or the ECB’s medium-term inflation target in the bargaining process. The two were very close to each other. In the current rounds of negotiations, current inflation rates and the loss of purchasing power are expected to play a greater role than in the past. Labor market shortages are likely to increase the bargaining power of unions, which may prioritize higher wages over job security.

Overall, the relevance of wage deals depends on how much of a country’s employment is covered by collective agreements – and in the eurozone, that’s a lot. On the other hand, collective bargaining agreements, whether centralized or decentralized, have a strong signaling effect on wage agreements in the private sector. The result is a strong relationship between aggregate wage growth and “negotiated” wage growth.

For the euro zone, we find that the correlation between negotiated wages and inflation is the strongest with a two-quarter lead for inflation. This means that wage growth historically tracks inflation by about six months.

Inflation drives wage growth, as it is an important driver of wage negotiations

Inflation leads wage growth in the Eurozone, being an important driver of wage negotiations

Inflation and wage growth in the euro area

Eurostat, ECB, ING Research

Corporate earnings have been strong, supporting wage growth

Besides factors such as labor shortages and purchasing power, another important driver of wage growth in the Eurozone is the ability of companies to afford wage increases. If corporate profits have weakened, we can expect a slowdown in wage growth. However, healthy corporate profits should increase the likelihood of wage increases, sharing corporate profits with employees. The relationship historically shows a lag of five quarters. At the current juncture, corporate earnings have shown a particularly strong rebound since economies reopened in mid-2020, suggesting ample room for higher labor compensation over the course of 2022.

A high share of corporate profits paves the way for earnings growth

The high share of corporate profits creates room for growth in compensation.

Share of gross profits of non-financial corporations in the euro area, annual change in negotiated wages

Eurostat, ECB, ING Research

Minimum wage increases have been generous this year

Another important factor contributing to higher wage growth in 2022 is the significant increase in the minimum wage in several countries. Germany is the most notable, of course, with an expected increase to €12 per hour promised by the new coalition (an increase of almost 30%). Other countries have also seen the minimum wage increase, such as Portugal with a 6% increase, while France and Belgium will adjust to inflation, which will result in a significant jump. The Netherlands has also agreed to raise the minimum wage by 7.5%, but will do so in stages throughout the government’s term. The impact of a higher minimum wage is of course passed on to the average, also because it generally affects wage categories above the minimum as well.

Expect wage growth to rebound to around 3% this year

A simple empirical model that has worked well historically would suggest that nominal wage growth would recover to around 3-3.5% over the course of 2022, but the relationships in economics are rarely mechanical. Keep in mind that Germany has relatively few upcoming wage negotiations, which is holding back the growth of negotiated wages. Furthermore, a key question is whether unions – whose positions have weakened in recent decades – can convert better bargaining positions into higher wage growth.

On the other hand, aggregate wage growth in sectors without collective bargaining already appears to be significantly higher than wages negotiated in some euro area markets, although the data on this is currently heavily skewed due to composition effects in labor cost index data. Overall, therefore, we believe that wage growth of around 3% seems like a reasonable number for wage growth to rebound, possibly over the next couple of years.

We expect wage growth to reach the 3-3.5% range this year

ING Research expects wage growth to reach 3-3.5% this year.

Negotiated wage growth, historic and expected rise (ING forecast)

ECB calculations, ING Research

So, is the Phillips curve alive and active then? It seems so, although it looks like he needed supply shock therapy to revive. The current high inflation is of course not the result of low unemployment, but it will in turn feed through to the wage growth channel, which in turn will inflate medium-term inflation estimates. . This is only the beginning, but it seems that the relationship between unemployment and inflation is becoming more important again.

For the ECB, this will be an important argument for a rate hike in early 2023. For the current inflation peak, policy is not so relevant. The ECB can hardly fill the gas reserves or add to the shortage of containers. What it can do is act on cyclical developments that look favourable, with the economy recovering faster than expected and wage growth expected to rebound this year. With inflation expectations around 2%, ECB President Christine Lagarde will have the luxury that former President Mario Draghi never had: raise interest rates.

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