Possible wage increases in the current context

The high wage growth, albeit below inflation, raises the question of the room for further wage increases at the current juncture.While wage developments appear constrained in some Member States, in the sense that they do not react to their usual macroeconomic drivers in the way they used to (Section 2.4.1.), assessing the room for higher wage growth also requires looking at the possible effects of further wage increases on both inflation and competitiveness (Section 2.4.2.).

Wage developments between Member States and the rebalancing effects

In many Member States, wage growth has been reacting less strongly to inflation and unemployment than before the pandemic, suggesting that there is room for further wage increases, at least in some countries.The observed growth of nominal compensation per employee can be compared to a ‘benchmark’ growth rate predicted on the basis of developments in inflation, productivity growth and unemployment . In 2022, wage growth was more than 2 percentage points below its benchmark in all Member States except Luxembourg (with a gap of 0.3 percentage points) and Bulgaria (with a sizeable positive gap, meaning it was above the benchmark, of 7.5 percentage points). Some of the Member States with the lowest wage growth in 2022 were also among those with the largest (negative) gaps in relation to the benchmark (e.g. Ireland, Spain, the Netherlands and Slovenia). For 2023, wage growth is expected to remain below its benchmark in 19 Member States, with a gap of more than 2 percentage points in 8 Member States (Czechia, Ireland, Greece, Croatia, Italy, Hungary, Romania and Slovakia). Positive gaps are expected in only 7 Member States (Belgium, Bulgaria, Estonia, Latvia, Lithuania, Luxembourg and Austria) (Graph 2.8). These persistent and high negative gaps suggest some room for further wage increases, at least in some countries.

Graph 2.8: Gap in wage growth relative to its benchmark (%)

Additional information about graph 2.8

The graph consists of a bar chart showing the gap between actual wage growth and the wage growth predicted based on on the evolution of inflation, productivity and unemployment. The graph shows figures for each Member State, for the years 2022 and 2023. In 2022, in all Member States except Belgium the gap was negative – meaning that acual wage growth was below the growh predicted based on economic fundamentals. While for Bulgaria the gap was 7.5%, for the other Member States this ranged from 0.3 (Luxembourg) to 12.4% (Greece). In 2023, the gaps are smaller in absolute value for all countries, and are positive in other six countries in addition to Bulgaria: Luxembourg, Belgium, Estonia, Latvia, Lithuania and Austria. The gap is at or just below zero in Cyprus, Malta, Slovenia and Denmark. It is between -1% and -3% in Poland, France, the Netherlands, Finland, Portugal, Spain, Sweden, Germany, Romania, croatia, Hungary and Slovakia. And, it is between 4% and – 5% in Italy, Greece, Czechia and Ireland.

Note

(1) Wage benchmark is predicted by developments in inflation, productivity and unemployment rate.

Source

Own calculations based on AMECO [1100 OVGD, 1000 NETD, 3099427 XUNRQ, 1000 ZCPIH, 1000 ZUTN, 1000 UWCD, 1000 NWTD] and Eurostat [ert_eff_ic_a, une_rt_a_h].

Recent wage developments may contribute to an overall rebalancing of intra-EU competitiveness, except for some Member States.Persistent differences in wage growth may affect competitiveness, notably in the euro area, as the exchange rate cannot adjust for these differences. Some euro-area Member States, notably the Baltic states, Belgium and Luxembourg, are expected to face higher unit labour cost growth than the other Member States over 2022–2023 (and growth significantly higher than the pre-pandemic rates), potentially worsening their cost competitiveness (Graph 2.A1.4 in Appendix 1). Conversely, more moderate wage growth in some southern European Member States (such as Greece, Spain, Italy and Cyprus) may allow them to regain some cost competitiveness, notably vis-à-vis other euro area countries (including Germany and the Netherlands).

Possible effects of further wage increases on inflation and competitiveness

The high current and expected nominal wage growth has reignited the debate about its possible effects on inflation.Despite headline inflation decreasing since its peak in October 2022, core inflation (headline inflation excluding energy, food, alcohol and tobacco) has been more persistent and reached a historic high of 6.6 % in the EU in March 2023 before moderating slightly. Since the end of 2022, core goods and services have replaced energy and unprocessed food as the primary driver of headline inflation in the euro area. According to the European Central Bank (ECB), labour cost developments have been an important factor behind the persistence of the underlying inflation, with wage growth becoming a concern for some non-financial companies in the euro area .

Graph 2.9: HICP, harmonised index of consumer prices. The survey covers the Euro area.

Additional information about graph 2.9

This figure shows the developments of inflation between 2010 and 2023Q3, short-term inflation expectations (i.e. expectations at a given time of what inflation will be 12 months later – going up to 2024Q2) and long-term inflation expectations (i.e. expectations at a given time of what inflation will be 24 months later, going up to Q2 2025).

As regards inflation, it has remained between around 3% and 0% from 2010 until 2020, reaching sometimes negative values in 2015, 2016 and early 2020. Inflation went up drastically after that, peaking at around 10% in mid-2022 and then going back to around 4% in early 2024. Both short-term and long-term inflation expectations remained between 1% and 2% from 2010 until mid-2022, despite the inflationary trend observed since 2020. As of mid-2022, short-term expectations have somewhat increased (peaking at around 4% in 2023 but moderating to around 3% in 2024), although long-term inflation expectations have remained below 2.4%.

Note

HICP, harmonised index of consumer prices. The survey covers the Euro area.

Source

ECB Survey of Professional Forecasters and Eurostat [prc_hicp_midx].

However, wage growth does not appear to be exacerbating inflationary pressures so far, as inflation expectations remain anchored. Even if high wage growth can have some impact on current inflation in the short term (as businesses may adjust prices to cover part of the recent pay rises), the risk of wages fuelling a sustained rise of inflation predominantly stems from a possible de-anchoring of inflation expectations . Currently, inflation expectations 2–4 years ahead remain broadly stable between 2.1 % and 2.5 % (see Graph 2.9) .

Developments in profit margins also indicate that firms in some sectors may have room to accommodate wage increases without raising prices significantly.On average, profit margins have been resilient so far (see Graph 2.3) and are expected to remain broadly stable over 2023 . This suggests that some firms should be able to absorb further wage increases by reducing profit margins instead of raising consumer prices. Such wage increases, therefore, would not contribute to unintended inflationary pressures or jeopardise competitiveness . Against this backdrop, the profitability outlook is better for some services, thanks to resilient demand, than it is for manufacturing. This could notably help accommodate further increases in statutory minimum wages, as minimum wage earners tend to be better represented in some services.

At the same time, some second-round effects may occur, notably from higher than expected pay rises in services and if profit margins are not adjusted, which calls for scrutiny. In manufacturing, on top of less dynamic wage prospects, firms are less able to raise consumer prices . Therefore, second-round effects on inflation stemming from wage increases in manufacturing are expected to remain limited. By contrast, firms in some services (including food, retail, trade, transport and accommodation) have so far been able to pass part of the higher costs on to consumer prices (notably due to resilient consumer demand and supply constraints) and in some cases to increase their profit margins. This has been contributing to the persistence of core inflation . Looking forward, price pressures could turn out to be more persistent, for instance if wages accelerate more than projected, and without an adjustment in profit margins. In this regard, in some countries experiencing a high inflation, a greater level of competition and a more frequent price setting on the markets can curb inflationary pressures by constraining profit margins. Some national governments have been paying increased attention to insufficient competition in certain sectors, particularly retail (e.g. in Germany, France, Hungary and Portugal), while others have implemented value added tax cuts . Over the medium term, according to the ECB, profit margins are, however, expected to weaken owing to the monetary-policy-induced easing of demand, further improvements in supply chain constraints and some catch-up in real wages .

Notes

  1. For more details on the methodology, see European Commission (2022b).
  2. The ECB has different indicators to measure underlying inflation; the indicators’ aim is to measure the inflation stemming predominantly from market forces, in the absence of disturbances. For more details on the concept, see Ehrmann et al. (2018). In January 2023, the ECB contacted representatives of 73 leading non-financial companies. Most of these firms expected wage growth to be higher in 2023 than in 2022, with some expressing concerns that wage increases were permanent and would thus have longer-lasting effects. See European Central Bank (2023a).
  3. See European Commission (2022b).
  4. For instance, according to the ECB’s Survey of Professional Forecasters for the first quarter of 2023, the average longer-term inflation expectations (for 2027) have fallen to 2.1 %. In addition, in the ECB’s Consumer Expectations Survey for July 2023, median expectations for inflation 3 years ahead had remained relatively stable at around 2.4 %. The January 2023 Consensus Economics Survey reported broadly unchanged longer-term expectations, standing at 2.1 %.
  5. See European Commission (2023b).
  6. The decline in real unit labour costs in the EU (1.8 % in 2022, and forecast at 0.6 % in 2023 and 0.7 % in 2024) also means that average prices have been growing at a higher pace than unit labour costs, suggesting that some firms have more capacity to increase wages (notably where the consumer prices for their products have increased more than the costs of production). For a quantitative assessment of the room to raise wages, see: European Commission (2022b).
  7. Depending on the sector and how product markets work, wage increases can be passed on to consumer prices, but firms in the tradable sectors are generally less able to do so, as they are subject to international competition. For more details, see: European Commission (2022b).
  8. Prices have remained dynamic, particularly in the food retail and agro-industry sectors and for many services, contributing to core inflation.
  9. The contribution from unit profits to inflation notably stands out in Bulgaria, Czechia, Hungary, Poland and Romania. The developments in unit profits (profits as share of value added) can serve to assess the impact of profits on inflation, even if an increase in unit profits does not necessarily entails a higher profit margin (profits as a share of sales).
  10. According to the ECB, to the extent that profits arise due to insufficient competition in certain sectors, the competent competition authorities should take action to enforce prohibitions on the abuse of dominant positions and ensure the removal of undue entry barriers.
  11. See: European Central Bank (2023b).