The ECB’s Throuple… Or Trouble?

By Bas Van Geffen, senior macro strategist of Rabobank

The accounts of the July ECB meeting noted that September “was widely seen as a good time to re-evaluate” the level of monetary policy restriction. But caution remains the key word. In fact, it appeared six times throughout the accounts of the deliberations. The Governing Council agreed that the triangular relationship between wages, productivity, and profits is key for the inflation outlook – but is it a happy throuple? Yesterday’s data releases brought policymakers some good news, but also some things to worry about.

The latest wage data should encourage the ECB to cut rates again in September. Euro area negotiated wages rose by 3.55% y/y in Q2. That’s a sharp decline from the 4.7% recorded in the first quarter of the year. The deceleration from Q1 is at least partly reflecting the one-off payments that were awarded in Germany at the start of the year. It remains to be seen whether wage pressures ease further: If we look at the underlying trend, i.e., excluding one-off cash payments, collectively agreed wages in Germany have been much more stable around the 4% y/y level.  

The August PMI survey broadly confirmed that wage pressures are gradually fading, but they remain at an elevated level. Input costs “continued to increase markedly,” but eased to the slowest pace this year. It’s particularly notable that the services sector reported the softest pace of input cost increases since April 2021, considering that wages are the largest share of their cost base.

But, absent a sharp increase in labour productivity, the annual growth rate of negotiated wages is still inconsistent with price stability. The ECB expects labour productivity to increase by about 1% in 2025 and 2026. That’s twice the average annual growth rate since 2000! Admittedly, higher demand may give productivity a boost, because it may force idle, hoarded labour to get into gear. Even so, if productivity increases by 1% –as the ECB predicts– and wages are rising by 3.5%, that’s roughly 2.5% inflation. Besides, policymakers acknowledged that this “expected pick-up in productivity […] had yet to appear in the actual data.”

And are profits equally encouraging? Even though purchasing managers reported a slower increase in their input costs, companies undertook bigger price hikes in August. Selling prices rose at the fastest pace in four months, and at an above-average pace. So while the ECB’s rate setters rejoiced that “domestic cost pressures from high wage growth, including in the services sector, had been increasingly buffered by unit profits,” the latest PMI survey suggests that companies may be expanding their margins somewhat again.

Ongoing expansion of profit margins actually has the ECB concerned about the efficacy of its monetary policy. The Governing Council discussed whether its restrictive stance is sufficiently affecting all parts of the economy, and especially the sector that is currently responsible for the strongest inflationary pressures: “the continued growth of profits in the services sector, albeit at lower rates, and the strength of services demand suggested a weaker transmission of monetary policy.”

Such concerns do not scream rapid rate cuts. Yes, another rate cut or two would still leave policy in restrictive territory, but whether it is also restrictive when rates drop to 3% or lower is less clear. Yet, the market continues to price a decent chance of back-to-back rate reductions. That may reflect concerns about the strength of the Eurozone economy: the PMIs did not exactly paint a rosy outlook for activity. However, in an outlook that looks increasingly stagflationary –as some ECB policymakers also concluded– can the ECB really afford to focus on the “stag-” half when the “-flationary” part has exceeded the target for so long? It would certainly require a leap of faith that the slower growth also leads to less demand-pull inflation in the period ahead, and that inflation expectations remain anchored until this happens.