Bringing down interest rates: are wages throwing a spanner in the works?
As Christine Lagarde wrote in her recent blog post, the ECB decided to lower interest rates in June 2024 by 25 basis points – the first such cut in some time. Inflation has indeed been falling sharply and is expected to continue to decline. But is it completely under control?
Stubborn services inflation
New data on wage growth indicate that wages in the euro area were up 5% year-on-year in the first quarter of 2024. That’s a bigger rise than had been expected at the end of 2023, and wages could well put further pressure on inflation. Services inflation, in particular, remains stubbornly high, at 4%.
Against this backdrop, it’s not a foregone conclusion that monetary policy decisions will provide for further rate cuts in the coming months. Euro area central bank governors would like to avoid having to take a step back should inflation again rise significantly above the ECB’s 2% target. According to both the financial markets and the ECB Survey of Monetary Analysts (SMA), conducted in late May, we can expect policy rates to be lowered once or twice more by the end of 2024. This lowering of interest rates may, however, be less rapid than the rate hikes of 2022 and 2023.
Headline inflation
(%)
Labour costs are the culprit
Wage growth is keeping services inflation high and is thus an indicator that is being closely monitored by the ECB. Inflation in services - a key component of the consumption basket, with a share of over 40% - rose sharply in 2022. Wages account for a significant share of the total cost structure in the services sector, meaning the persistently high inflation seen in this sector is partly due to labour costs. Other factors are also playing a role, however, such as the delayed reaction to general cost increases. In Belgium, for instance, the prices of some services are automatically indexed (rent, insurance contracts, etc.). Although services inflation is high in historic terms, we are over the hump.
Wage growth has been exceptionally high in the euro area since 2023. In that year, it averaged 4.6% and rose further, to 5%, in the first quarter of 2024. This was due to workers seeking compensation for sharp increases in prices. The tight labour market, with companies struggling to find workers, has worked to their favour. In the euro area, wage increases are largely negotiated, which takes time; on average, wage agreements are concluded for a period of two years. Thus, in certain sectors, wage negotiations can take place long after a spike in inflation. That’s why the ECB was not too concerned by the further rise in wage growth observed this year, as such fluctuations are considered “normal” given the wage formation process.
Meanwhile in Belgium...
In Belgium, the process is different. Almost all employees benefit from automatic wage indexation, and only wage increases above indexation-based raises can be negotiated (so-called real wage increases). Thus, wage growth began much earlier in Belgium than in the rest of the euro area and has been more robust. In the first quarter of 2023, wages grew by 9.1%. This rate dropped sharply to 2.5% in the beginning of 2024. Wage growth in the euro area is expected to remain high for longer, while in Belgium it will continue to fall, even dropping below its long-term level.
Wage growth and services inflation
(year-on-year growth, %)
No wage-price spiral
Inflation-driven wage growth can trigger a “second round” of inflation. In other words, a wage-price spiral can develop, with wages and prices feeding off one another and continuing to rise. This time around, an uncontrolled spiral may have been avoided, in part thanks to the sharp fall in energy prices in 2023 from their levels of the previous year. Furthermore, firms were able to use the profit buffers they had built up in preceding years to partially absorb cost increases.
Service prices, the persistent component of inflation, are thus one reason why interest rates could fall at a slower pace than that at which they were raised in 2022-2023. As ECB President Christine Lagarde put it in her blog post, the road to stable inflation “will not be an entirely smooth ride”. It will take time and require vigilance for all components of inflation (including services) to stabilise.
You can read President Lagarde’s blog post, “Why we adjusted interest rates”, here.
