This sequential process takes time as the economy moves through the different phases. In the current cycle, eurozone wage growth eventually accelerated, even significantly in some countries, in conjunction with a decline in the unemployment rate and the emergence of labour market bottlenecks. The real issue is the transmission of higher wages into higher inflation, which has been until now very limited.
What does this mean for the outlook for monetary policy? In recent months, bottlenecks have eased considerably in manufacturing, although they still remain above previous cyclical peaks. In services and construction they have stabilised at a very high level. Profit margins (gross operating surplus as a percentage of value added) have been on a declining trend, which may increase the reluctance of companies to yield to demands for higher wages if they consider that the slowdown in sales weakens their pricing power. Should there be re-acceleration in growth, bottlenecks would resurface quite soon leading to faster wage growth, which should lead to a pick-up in inflation. The question is how much and how fast? In this respect, Bundesbank research shows that, in Germany, a 1% increase in wages results in a 0.3% increase in consumer price inflation. “However, it takes considerably longer than one year for the cyclical adjustment of prices to a wage shock to be largely complete.”[4] This could imply that part of the recent pick-up in wages still needs to show up in German inflation. A factor which may complicate matters is that, according to research by the ECB, a low inflation environment is associated with a more moderate pass-through.[5] Finally, empirical research by the IMF shows that the impact of faster wage growth on inflation builds up gradually, peaking after about 6 quarters. “Overall, the passthrough ratio—defined as the ratio between the cumulative change in prices and the cumulative change in wages—is about a third.” Moreover, this transmission is more moderate when inflation is low, when inflation expectations are well-anchored and when competition (foreign as well as domestic) is intense. On the other hand, declining profit margins tend to cause a bigger transmission, but in a competitive environment, this puts companies between a rock and a hard place: increasing prices to protect profit margins may come to the detriment of sales volumes.
To conclude, the bottlenecks which remain high (though less than before in manufacturing, because of the crisis in this sector) has already led to somewhat higher wage increases. These will gradually filter through in a pick-up in inflation, but such a process takes several quarters and, as shown by empirical research, a number of conditioning factors (low inflation, well-anchored inflation expectations, intense competition in certain sectors) may very well moderate this transmission. Given the firm conditions set by the ECB Governing Council before envisaging a change in policy, it thus seems clear that the current policy will remain in place for a considerable time. How long ’considerable’ turns out to be will depend on the data. The eurozone clearly needs more growth.
