Wage growth could jeopardize the medium-term inflation target of two percent

Thanks to a surprisingly strong decline in inflation in recent months, financial markets expect the European Central Bank (ECB) to cut interest rates by 25 basis points for the first time in April. Meanwhile, ECB leaders are cautiously awaiting the final outcome of a large number of ongoing wage negotiations, which are expected to result in a wage increase of six percent in 2024, a key factor that could jeopardize the medium-term inflation target of two percent, writes the chief economist of HUP, Hrvoje Stojić, in the Focus of the Week.

Wages already grew by an average of over five percent last year, approximately in line with average inflation. Given that about 40-60 percent of companies in the service sector report a labor shortage as a serious threat to business, we expect further pressures on wage growth in the real sector.

In the medium term, wages should not grow by more than two percent plus productivity growth if the ECB wants to achieve a targeted inflation rate of around two percent. However, the ECB estimates that productivity fell by 0.8 percent last year and that it will achieve only a below-average increase of 0.4 percent in 2024. Therefore, wage increases of five percent (or more) are not compatible with the ECB’s medium-term inflation target.

– Core inflation will further slow in the coming months as the easing of inflation in energy and food prices helps to slow inflation in other goods and services. By mid-year, core inflation could fall to a level of 2.5 percent, but in the second half of the year, relatively strong wage growth could spill over into inflation trends. By the end of the year, inflation could be closer to three percent than the targeted two percent, writes Stojić.

The main rate could reach two percent in 2025.

Of course, interest rates have long been in focus for leaders, and this week Robert Holzmann, a member of the ECB’s Governing Council in Davos, said that threats arising from prolonged inflation will prevent the ECB from reducing interest rates this year, even if a recession occurs. The eurozone economy has recently disappointed and it is likely that officials will prove to be overly optimistic following the release of fourth-quarter results, Holzmann said in an interview on the sidelines of the World Economic Forum.

Inflation was close to the ECB’s target of two percent at the end of last year, which sparked speculation about when policymakers would reverse the largest monetary tightening campaign since the introduction of the euro 25 years ago. Traders are betting on six cuts of a quarter point, starting in April, while economists predict the first of four moves in June.

Holzmann reiterated the stance of his colleagues, including ECB President Christine Lagarde and Chief Economist Philip Lane, that it is ‘too early’ to talk about reducing borrowing costs.

– If such a date were set, it would immediately trigger dynamics that we cannot control. And with all the knowledge we currently have, it would not be fair to do so because we do not know how inflation will develop, Holzmann said, who also heads the Austrian central bank.

The ECB currently predicts that the main rate will reach two percent in the second half of 2025, while pressures on core prices are expected to remain above that threshold until the end of 2026.