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Low wage growth in the Eurozone to limit the ECB’s upside


  • So far, none of the ECB’s self-imposed criteria for inflation have been met and signs of second-round effects following the surge in headline inflation since mid-2016 remain scant
  • We look into a number of cyclical and structural explanations as to why this might be the case
  • Besides the observation that there may simply be more slack in the labour market than suggested by the headline unemployment numbers, we also conclude that the bargaining power of labour has significantly declined over the past decade
  • As this is likely to be structural in nature, the long-awaited pickup in wage growth may take even longer than the ECB has been hoping for
  • This is unlikely to deter the ECB from winding down QE next year on technical grounds, but it is likely to prevent it from hiking their deposit rate in 2018

He’s said it now!

Truth had to be told. In the 8 June press conference, Mario Draghi, arguably for the first time in his tenure, went out of his way to explain the “flat and low profile” of underlying inflation. Subdued nominal wage growth, according to the ECB President, is the result of broad labour market slack, (structural) changes in the labour market and a rise in ‘low quality’ jobs. Draghi broadly reiterated that view in a speech in Sintra on 27 June.

The upshot of the ECB’s message is that we simply need to be patient, as things will improve over time. Upward pressure on wages and core inflation will eventually re-establish itself. But the key question is whether the factors that are holding back wage growth are transitory. And if so, how long it will take for them to disappear. Timing is crucial as the ECB has made its highly accommodative policy stance dependent on a durable return of inflation. We expect the ECB to announce a phasing out of QE before the December policy meeting. The programme should then be wound down by mid-2018. But we expect rates, including the negative deposit rate, to stay unchanged until at least the end of 2018 (and probably longer) as significant upside pressure on (core) inflation remains absent.

Recent experience from the US suggests that it may take (much) longer for wage pressures (and thereby pressure on core inflation) to emerge than what was generally the case before the Global Financial Crisis and this begs the question whether we will see a similar development in the Eurozone. The straightforward explanation is that there is just more slack in the labour market. But we find an alternative narrative behind low wage inflation combined with rising employment growth, as currently seen in many Eurozone member states.

Figure 1: Headline inflation has soared - but core inflation still has not
Figure 1: Headline inflation has soared - but core inflation still has notSource: Macrobond
Figure 2: Diffusion indices: deflation risks have been falling since 2015
Figure 2: Diffusion indices: deflation risks have been falling since 2015Source: Macrobond, Rabobank

Employment growth may be the result of wage growth being depressed by a different allocation of capital (away from high-productivity/high-wage sectors to low-productivity/low-wage sectors). Labour market developments such as falling unionisation and a rise in a-typical labour contracts are a further reflection of the lower bargaining power of employees. If such trends persist, it may take much longer before we see a sustainable pickup in wages.

In this research note, we argue that the ‘breakdown’ in the Phillips-curve (the negative relationship between wage growth and unemployment) is partly structural. But before doing so, we look at some recent developments in (underlying) inflation, the ultimate gauge for the ECB.

Four conditions – but none met thus far

Headline inflation peaked at 2% in February, the highest rate in four years, but has eased since, albeit with considerable volatility. In the January 2017 press conference, responding to a question about how much inflation the Governing Council would tolerate, ECB president Draghi said:

“Now, the answer […] lies in what we define as our objective. We define our objective first of all in the medium term […]. Second, it has to be a durable convergence, so it cannot be transient. Third, it has to be self-sustained. In other words, it has to stay there even when the extraordinary monetary policy support that we are providing today will not be there. Fourth, it has to be defined for the whole of the eurozone.”

That response has taken a prominent place in the ECB’s statements of late. In the June statement, for example, the ECB continues to argue that its asset purchase program is “[…] intended to run […] until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.” And in the ECB’s inflation assessment it is stated that “[…] the economic expansion has yet to translate into stronger inflation dynamics. So far, measures of underlying inflation continue to remain subdued.”, which basically serves as an alternative to the “downside inflation risk” assessment, which has not featured ECB statements since September 2015.

Figure 3: Producer output prices, notably at the intermediate stage, are rising...
Figure 3: Producer output prices, notably at the intermediate stage, are rising...Source: Macrobond
Figure 4: ... but so far this is hardly visible in non-energy industrial goods or services prices
Figure 4: ... but so far this is hardly visible in non-energy industrial goods or services pricesSource: Macrobond

Broadly speaking, when we translate the ECB’s conditions into 'measurable' indicators, we would argue that none of these conditions has yet been met:

  • The sharp pickup in inflation is relatively recent and the ECB’s medium-term projections are not consistent with the objective of price stability having been met over the medium term; the ECB’s staff projection for 2019 now stands at 1.6% (1.7% for core). President Draghi himself acknowledged in December 2017 that 1.7% “is not really” in line with the ECB’s of price stability objective of “below but close to 2%” (although perhaps some GC members would be perfectly ok with this).
  • The fact that the recent pickup has been almost exclusively driven by food and energy costs implies that it clearly fails the ‘durability / non-transient’ test, although the number of components in the HICP that is rising in YoY terms has picked up since 2015 (figure 2).
  • According to the ECB its programs are having a sizeable impact on growth (and thus inflation) projections; so from this we should conclude that taking monetary support away at this stage would lead to lower growth and inflation forecasts (this, though, is speculative and we should add that we have always been sceptical about the efficacy of QE). But the ECB’s view is enshrined in recent policy statements by “[…] very favourable financing conditions are necessary to secure a sustained convergence of inflation rates […]” and that “a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term”.
  • We see substantial heterogeneity in inflation levels and developments across the Eurozone.

Any second round effects, then?

With energy and food being the key drivers of recent inflation, this raises the question as to whether this is leading (or will lead) to second-round effects.

The most recent period to compare any current second round effects with is 2009-2010. At that time the global economy was recovering from the deep Global Financial Crisis. It then took almost 1.5 years before the sharp rebound in headline inflation became visible in (super) core inflation (core inflation rose earlier because of higher VAT and administered prices – means for governments to quickly plug budget holes). However, since the recovery at that time was driven in particular by strong growth elsewhere (notably in Asia/China), this might explain the long delay. This time around, therefore, things may be slightly different as growth in the Eurozone appears to be driven mostly by domestic factors, raising the possibility that the pass-through will be quicker.

From this perspective, we would likely to highlight four transmission channels:

  • ‘Pipeline effects’ from producer (energy) input costs to factory gate prices and profit margins to higher consumer prices
  • The exchange rate
  • Rising inflation expectations (notably among the broader public), which ultimately feeds into:
  • Higher wage inflation through wage demands and indexation mechanisms

Limited pipeline effects thus far

At this point it seems that second round effects of the rise in energy costs are still limited. At the intermediate stage, producer prices are now rising quite sharply, at over 4% YoY, but this seems mostly energy-related. Price increases in non-energy industrial goods at the consumer level remain very limited (see figure 4).

Moreover, commodity prices have slipped again this year, with the decline in the Bloomberg commodity price index since mid-April having reached almost 6%. On top of this comes the recent strength in the euro. The trade-weighted average has appreciated by nearly 4% since mid-April. Altogether this may slow down the pass-through of past rises in producer prices.

Figure 5: Inflation expectations from surveys are rising, but from a low base
Figure 5: Inflation expectations from surveys are rising, but from a low base Figure 6: Economic slack (in the traditional sense) is declining, but we’re not there yetSource: Macrobond
Figure 6: Economic slack (in the traditional sense) is declining, but we’re not there yet
Figure 6: Economic slack (in the traditional sense) is declining, but we’re not there yetSource: Macrobond

Short-term expectations rising…

While market-based inflation indicators (forwards on break-even rates) rose rather sharply in 2016, driven by higher commodity prices (oil) and ‘reflation’ expectations on the back of the election of US President Trump, the positive momentum has faded and the 5y5y inflation swap forward is again trading at 1.55%, about the same level as early 2015, when QE was announced.

More relevant for the development in core inflation this year, in our view, is the extent to which rising inflation is feeding into inflation expectations among the broader public (both companies and households) and to what extent this then feeds into higher pay claims and prices.

Recent data from European Commission surveys (figure 5) are at least pointing at a rise in such (short-term) price expectations, but the forecasting power of these surveys tends to be weak (they mostly correlate with current inflation) and they are rising from a low base. In other words, it is not clear whether or not this will have any bearing on future wage negotiations. Below we argue that there are several reasons to believe that it will not.

No more pass-through from indexation mechanisms?

Several Eurozone member countries, among which Greece and Spain, have removed automatic wage indexation mechanisms over the last decade. Other countries already did so in the 1980s and 1990s. These indexation rules ensured that past rises in inflation (usually a specific domestic measure of prices), fed, partially or wholly, into (collective) wage agreements. Some form of indexation is now only to be found in Cyprus, Luxembourg and Belgium (in France it mainly pertains to minimum wages and social benefits). This implies that second-round effects from the rise in headline inflation since mid-2016 are less likely to filter through to wages and hence core inflation than might have been the case in the past.

Figure 7: J-curve in ECB staff wage projections: continued disappointment
Figure 7: J-curve in ECB staff wage projections: continued disappointmentNote: compensation per employee
Source: ECB, Rabobank
Figure 8: … whilst productivity has tended to be weaker than forecast as well
Figure 8: … whilst productivity has tended to be weaker than forecast as wellNote: productivity per hour worked, ECB source
Source: ECB, Rabobank

… but economic slack has not disappeared

This also means that the extent to which such second-round effects manifest themselves will first and foremost depend on the amount of slack in the markets for products and services (i.e. the ability of companies to raise margins by increasing prices) and on the labour market (i.e. the ability of employees to push for higher wages). On this point, the jury is still out. Going by the European Commission’s capacity utilization rate in industry, spare capacity in the sector may have evaporated already. But broader indicators such as the output gap (such as the gap between GDP and potential GDP by the European Commission) and the gap between the unemployment rate and the NAIRU, indicate that it may take at least another year before ‘full capacity’ has been reached (see figure 6).

And perhaps it will take much longer, if one acknowledges that that all these ‘cyclical’ capacity utilization measures are difficult to measure, inherently unstable and are often revised. Structural reforms in e.g. Spain and to a lesser extent Italy are likely to have reduced structural unemployment there, a point we will zoom into in the following sections.

Lessons on wage growth from the US and UK

Since 2013, the ECB’s wage projections have been following the familiar ‘J-curve’, suggesting that the staff were expecting wage growth to kick off in a fairly rapid fashion as the unemployment gap started to narrow. Over-prediction of future wage growth has been the rule rather than the exception, as is highlighted in figures 7 and 8. Although forecasts for productivity growth have been weaker than expected as well (having an upward effect on unit labour costs), the weak trend in labour compensation seems to be a key explanation as to why core inflation has disappointed.

One lesson that we may draw from the experience in the US and the UK is that labour market slack needs to reach a certain level before it starts having a material impact on wage growth. In both the UK and the US we find that wages started to take off only when the unemployment gap reached about -0.5% or higher, visible in figures 9 and 10. At the end of April, unemployment in the Eurozone was 9.3%. Over recent years it decreased about 0.9 percentage points per year. In this case, using the ECB’s estimate of the NAIRU at 8.5%, it would take until the end of this year for the unemployment gap to reach above -0.5%. Wage growth could then take off and would take longer still to work into core inflation about halfway next year. If, however, the NAIRU is lower, say around 8%, it may take as long as mid-2018 before wages take off.

Figure 9: US wage growth only started taking off as unemployment nearly closed
Figure 9: US wage growth only started taking off as unemployment nearly closedSource: Macrobond
Figure 10: UK wage growth and the unemployment rate show a similar pattern
Figure 10: UK wage growth and the unemployment rate show a similar patternSource: Macrobond

The disappearance of the Phillips curve

The subdued wage pressures seen in combination with rapidly decreasing unemployment are at odds with historical developments and standard economic theory. Indeed, for the euro area as a whole we see that this relationship, the Philips curve, has flattened since 2011. For Germany the curve is even upward sloping, meaning (recent) lower unemployment has corresponded with lower wage growth. This is shown in figures 11 and 12. Before the financial crisis, these Philips curves were more ‘well-behaved’. For France, Spain, Italy and the Netherlands (not shown), the recent picture looks similar. Before the crisis, Spain and Italy showed no strong relationship between wage growth and unemployment, in part because wage growth was characterised by strong wage indexation. After 2011, labour market reforms removed these indexation mechanisms, which, among other things, has led to substantially lower wage growth in these countries. In other words, one explanation for subdued wage growth in these countries is that there are still ‘pent-up wage cuts’ stemming from the pre-2011 period that need to work their way through the system. But for Germany such an explanation does not seem very probable.

Figure 11: The eurozone Philips curve is flat since 2011Q1
Figure 11: The eurozone Philips curve is flat since 2011Q1Source: Macrobond
Figure 12: In Germany it is even upward sloping
Figure 12: In Germany it is even upward slopingSource: Macrobond

The role of labour market reforms

In structural reforms we can already find a (transitory) reason for subdued wage growth. Another is that these same reforms and more explicit budget cuts, through sobering social benefits, have reduced the net replacement rate (i.e. unemployment benefits as a percentage of previous (net) income). This increases workers’ incentives to find work and take any job, even if it is for a low(er) wage. There is also considerable slack in the labour market, as explicitly noted by the ECB in a recent publication[1] (replicated in figure 14 on the next page). They present this in the form of an under-employment rate that takes into account slack in the labour force. They include part-time workers who want to work longer hours, people who are seeking employment but are unavailable to start immediately and those who are available but not currently seeking employment (i.e. discouraged workers).

When we look at this broader measure of unemployment, we can clearly see that it stands at a much higher level than the unemployment rate (18.5% currently versus 9.3% for unemployment). More important, though, is that the gap over the normal unemployment has widened since the crisis. From about 7.5%-points in 2007, the gap widened to 9.5%-points in 2014 and it has now eased back to slightly under 9%-points.

Figure 13: Labour market rigidities have fallen significantly in the periphery
Figure 13: Labour market rigidities have fallen significantly in the peripherySource: OECD, Rabobank Note: Core countries are AT, BE, DE, FR & NL, periphery countries are ES, GR, IE, IT & PT.
Figure 14: According to the ECB, there is increased slack present in the labour market
Figure 14: According to the ECB, there is increased slack present in the labour marketSource: Macrobond, Rabobank Note: 4 quarter moving average.

Part of this slack can be explained by demand for labour still being low (as in our unemployment gap analysis). Employers also use the improving labour market to hire people but are not willing to raise wages yet. Their profit margins have only just recovered to positive territory as pent-up ‘wage cuts’ and rising input costs (the reason for rising headline inflation) have kept a lid on their profitability.

We can additionally explain this high slack by labour market reforms undertaken, especially in the periphery. The OECD’s Employment Protection Legislation (EPL) index (figure 13) provides a nice summary. In the periphery employment protection is now at a lower level (on a simple average basis) than in core member states.

Reforms may have increased the potential labour force, albeit at a time that demand for labour is still low. Liberalisation means workers should find it easier to get a job in these countries, but more difficult to make strong wage claims. That most of these labour market reforms took place in periphery countries does not help to put pressure on wages; they already struggle with larger output and unemployment gaps than Northern European countries. Therefore the onus to deliver on wage increases is firmly put on the latter (e.g. Germany, The Netherlands).

What could be keeping wages down more structurally?

Besides all previous, more cyclical or transitory reasons, there are signs wages are being held down by structural trends. One narrative behind the current environment of low wage inflation combined with rising employment growth currently seen in many Eurozone member states is that employment growth is the result of wage growth being depressed by a different allocation of capital (away from high-productivity/high-wage sectors to low-productivity/low-wage sectors) and structural labour market developments such falling unionisation levels and a rise in a-typical labour contracts, which are weighing on the bargaining power of employees.

The share of employment in services has been rising for years, throughout the crisis and after. Many of these jobs have lower pay and have seen lower wage growth since the crisis. This trend is likely to continue: services sectors face intense(r) competition from abroad and new technologies (e.g. robots, AI) may put further strains on wage growth in this sector.

Figure 15: More jobs growth in low-capital intensive sectors*
Figure 15: More jobs growth in low-capital intensive sectors*Source: Rabobank, OECD, Macrobond
*) Total employment index by capital-intensity class, 4-quarter moving average
Figure 16: More jobs growth in low-wage/low-productivity sectors*
Figure 16: More jobs growth in low-wage/low-productivity sectors*Source: Rabobank, OECD, Macrobond
*) Total employment by wage/productivity class, 4-quarter moving average

When we look at the development in sectoral employment, there is a general trend towards higher employment growth in those sectors that have a low capital/labour ratio. Using the OECD’s STAN database and dividing all sectors (on a 2-digit NACE level) into ‘low’ and ‘high’ capital intensity class, we find that Eurozone[2] employment in the former has increased by almost 5%, whilst employment in the latter has increased by less than 1.5% since 2012, notably as jobs were shed in the sectors with a higher-than average capital intensity (figure 15). A similar development can be seen if we distinguish between sectors that have below-average wages and/or productivity and sectors that have above-average wages and/or productivity (figure 16). This lends some support to the view that wage growth may be caused by a different allocation of capital (away from high-productivity/ high-wage sectors to low-productivity/low-wage sectors). Of course, this development may in part also reflect the shift of employment out of manufacturing and into services sectors. This does not necessarily mean that wage growth should be lower, but if more jobs are created in low-wage/low productivity sectors, this could either point at composition effects or wage growth being constrained by the fact that more and more jobs are moving into low-productivity growth sectors.

Meanwhile – and perhaps partly because of the trends highlighted above – employees’ bargaining powers have been significantly eroded due to the nature of the jobs being created. This is also partly, but not exclusively, related to the labour market reforms seen since the 1990s and again since the sovereign debt crisis. Two observations stand out here:

  1. The use of flexible contracts and number of people in (involuntary) part-time jobs has risen sharply in many countries, notably in the periphery and among young people (figure 17)
  2. In some countries, in contrast, we see a sharp rise in the number of people having second or even third jobs; this seems to be especially prevalent in Germany, perhaps because jobs are in abundance

In other words, and perhaps put somewhat bluntly, for many employees it may be the case that they prefer to have a low-paid job over having no job at all.

And where are the unions?

Another structural trend seems to be the decreasing bargaining power of unions. Not only have they lost much of their formal position in wage bargaining, especially in the periphery, they have also lost support among workers. Before the crisis it was very common for wages in the periphery to be indexed to inflation or even higher. In the case of no agreement between unions and employers, the previous deal would still be applied. This effectively gave unions a veto over lower wage growth. Furthermore, unions were only responsible to their members and not to society in a broader sense. Reforms since then tore down the union’s strong position. Many countries adopted legislation that decentralised wage bargaining to the industry or even firm-level[3]. In the latter case unions are more thinly spread across firms and will find it harder to take a common stance. This may be one of the reasons that wage growth in Germany remains so tepid, despite calls by Bundesbank governor Jens Weidmann on German unions to increase their wage demands[4].

Finally, wage growth can only be sustainable in the medium and longer term if accompanied by labour productivity growth. And on that front there is not much uplifting news for the Eurozone, and indeed much of the developed world (figure 18).

Figure 17: Rising job insecurity
Figure 17: Rising job insecuritySource: Macrobond
Figure 18: Labour productivity growth stagnant in the developed world
Figure 18: Labour productivity growth stagnant in the developed worldSource: Macrobond
Note: Production per hour worked, 3-year moving average

Conclusions with – potentially – huge implications

Altogether we believe it is fair to conclude that wage growth – and henceforth core inflation – is likely to remain subdued in the foreseeable future as i) spare capacity in the labour market is probably bigger than traditional measures suggest, ii) past labour market reforms and pent-up wage cuts (due to nominal rigidities) still need to work their way through the system and iii) there are a number of factors that suggest that the bargaining power of employees has been reduced structurally.

Of course a faster than expected fall in unemployment, given the broad-based pickup in growth we have seen over recent quarters, could pose an upward risk to wage growth. But given the recent experience, it seems more likely that it will take even longer for wage pressures to rise in case the NAIRU is lower than the ECB currently estimates.

Potentially, this has huge implications for ECB policy as it may take considerably longer before (core) inflation reaches the levels the ECB sees as consistent with its objectives. Whilst hard to swallow, acceptance of that reality may well be the ECB’s fate, as it is being forced to wind down its asset purchase program because of technical factors.

But it may still influence the timing of the ECB’s first rate hike, notably if the tapering of QE leads to increased market volatility. Our judgement, as things stand, is that the slow recovery in wages and core inflation are likely to prevent the ECB from hiking its deposit rate next year.


[1] ECB Economic Bulletin, 11 May 2017

[2] Capital intensive sectors have an above-average capital stock to employment ratio. Countries included in this analysis are Germany, France, Italy, Spain, the Netherlands, Belgium and Portugal. There is significant heterogeneity between countries, a topic we have not covered here. Since the STAN data (ISIC Rev. 4 sector classification) do not include 2016/17 data, we have combined this dataset with more recent sectoral (NACE-2) employment data from Eurostat.

[3] In a sense this is also the fate of France, if Mr. Macron’s plans are implemented.

[4] Go to Financial Times.

Daniel van Schoot
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
Elwin de Groot
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 1389 2916

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