Wednesday, October 29, 2008

ECB still has wage pressures to contend with

The U.S. and Eurozone central banks meet this week and next, and markets are expecting rate cuts from both. However, the Eurozone still has wage pressures to contend with, while the U.S. does not.

Today the Federal Open Market Committee (FOMC) announces their decision for key interest rate targets, including the famous federal funds rate – the Fed’s target interbank loan rate. I believe that the market's expected 50 bps rate cut (yes a cut) is just a simple way to get the target down to the level of current effective federal funds rate (the actual interbank lending rate). I discuss this here. The Fed has introduced a plethora of liquidity into the banking system, liquidity that has driven the effective funds rate well below 1%, where the Fed's target is/was 1.5%.

Next week the European Central Bank will meet, and President Jean-Claude Trichet has indicated that a rate cut is on the horizon. From Bloomberg:
"European Central Bank President Jean-Claude Trichet said Oct. 27 he may reduce interest rates next week, citing ebbing inflation and ``weakening demand.'' The ECB, Fed and four other central banks trimmed rates by a half point on Oct. 8 in an unprecedented coordinated move.”
Compared to the Fed, the ECB has less wiggle room for its expansionary policy. First, it has an explicit inflation target equal to 2%. But second, and more importantly, the ECB is the central bank for 15 sovereign countries.

There is a short list of requirements that must be fulfilled in order for an EU member country to adopt the euro - including criteria over inflation, government finance, currency management, and long term interest rates - but that list does not include wage cost pressures. Certain countries – Germany, Spain, Belgium – have strong tendencies to index wages to the inflation rate, and in spite of strong wage pressures in key economies, the ECB must adhere to its 2.0% target.

The chart illustrates quarterly labor costs across the Eurozone spanning the years 2003-2008. Labor costs remain above the inflation target, 2.0%, and recently have risen with inflation pressures. Labor cost growth hit a peak in the first quarter of 3.5% and fell to 2.7% in the second quarter. With inflation receding on oil, wage pressures should subside a bit, but with inflation elevated, wage costs will be, too.

In Germany, where the labor market is strong and the unemployment rate is still falling (click here for chart), wage pressures are strong. Unions have bargaining power, and pressure firms to raise wages to meet elevated inflation, which is 3.6% in the Eurozone and 3.0% in Germany.

The chart illustrates monthly labor costs in Germany spanning the years 2003-2008. Labor costs in Germany are extremely volatile and fluctuate with inflation. Spanning 2006 and 2007, when inflation was falling, labor costs fell, while recently labor costs have grown with the surge in inflation. Inflation pressures are receding, but the headline rate sits at 3.0%, and strong labor conditions will likely drive labor costs upward to meet or exceed 3.0%.

Wage pressures that are stronger across Europe than in the U.S.

The chart illustrates U.S. quarterly labor costs in the U.S. spanning the years 2003-2008. Although unit labor costs in the U.S. do fluctuate with inflation, there is a stronger tendency for weak labor market conditions to keep wage pressures at bay. For example, current U.S. inflation sits at 4.9% and labor cost growth in the second quarter of 2008 was just 2.4%. On the other hand, Eurozone inflation is currently 1.3% lower than in the U.S., 3.6%, and labor cost growth exceeds that in the U.S., 2.7%.


Trichet will likely reduce the ECB’s target rate, but he needs to be careful - more careful than his counterpart Ben Bernanke must be. Wage pressures are strong in Europe, stronger than in the U.S., and the infamous cost-push spiral (wages pushing up prices) is an an ongoing risk for the Eurozone.

Rebecca Wilder

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