The ECB has released two Economic Bulletin analyses on wages in the Euro area (“Wage developments and their determinants since the start of the pandemic” and “Wage dynamics across euro area countries since the start of the pandemic”) and one comparing inflation developments in the US vs EA (“Inflation developments in the euro area and the United States”). This note explains why the ECB staff is optimistic and why core inflation in the US is set to decline faster than in the old continent. Implications for short-term and medium-term exchange rate dynamics are implicit.
What the ECB staff argues
ECB staff is in “La La land” and assumes “everything will be fine because the EA is not the US”. The three ECB staff notes sound like “there is little to worry about in the euro area, wage growth and core inflation will remain well below the US”. Specifically, the ECB staff argue that:
- In the euro area, wage growth over the next few quarters is expected to be very strong compared with historical patterns. However, the expected economic slowdown in the euro area and the “uncertainty about the economic outlook” are likely to put downward pressure on wage growth.
- Given the differences in labor market tightness, wage growth may remain stronger in the United States than in the euro area.
- Core inflation is foreseen to remain somewhat lower than in the United States in a context of continuing terms-of-trade losses and a less tight labor market.
The recent readings of AHE, core CPI in US and core HICP in EA could be enough to doubt of the ECB staff statements entirely. Nevertheless, we provide a full analysis below. Reality is the two continents are more similar than generally assumed.
The reality
We disagree with the ECB staff because the staff conclusion is in contradiction with its own charts, the evidence of the incoming data, and model-based forecasts. While the ECB staff argues that there are big differences between the US and the EA, some of the charts included in the analysis point in the opposite direction. For instance, V/U in the EA (see Chart B from ECB staff note reported in Figure 1 below) shows dynamics remarkably similar to the US (the Z-score of the two is essentially identical). Not only, but the ECB staff estimates that the relative contribution of demand-side factors in core inflation is higher in the EA than in the US right now (the reader can refer to chart D here). Put it differently: there are differences across the ocean but they are smaller than generally assumed, including by the ECB staff. Therefore, it remains unclear why the ECB staff continues to expect the euro area economy to behave differently than the US.
Figure 1. V/U in the US and EA from ECB Bulletin.
The ECB staff claims are at odds with incoming data that point to a deceleration in wage growth in the US and to an acceleration in the EA. Figure 2 and 3 show the growth rate of all available measures of wages and total compensation in the US and the EA, respectively (7 measures for each area). The top panel in each figure shows the 2018-2019 period, while the bottom panel shows the 2021-2022. The dashed horizontal line shows the level (3%) of wage growth consistent with a 2% inflation target, given 1% of structural productivity growth and no slack. The takeaway from Figure 2 and 3 is that while in the 2018-2019 sample all measures were running around the 3% line (in the EA all of them were below it), virtually all measures are now running above the level consistent with target in both, the US and the EA. Not only but while in the US some moderation is visible in recent quarters, in the EA wages and total compensation are accelerating much more than reported by the ECB staff. The reason why the ECB staff is unable to see and report it is because (in our experience) it relies almost exclusively on one (or two) indicators expressed as YoY instead of QoQ (ar). As basic as it might sound, we suspect (in fact, more than so) this is the reason why the ECB staff is underestimating the issue.
Figure 2. Measures of wages and total compensation in the US (QoQ, ar)
Note: “AFTW” stands for Atlanta Fed Wage Tracker (YoY), “AHE” stands for Average Hourly Earnings, “AWE” stands for Average Weekly Earnings, “CPH” stands for Compensation Per Hour, “CPH num” stands for Nonfarm Business Compensation (the CPH numerator), “ECI” stands for Employment Cost Index, and “ULC” stands for Unit Labor Cost. All figures are QoQ at annual rate, unless otherwise indicated.
Figure 3. Measures of wages and total compensation in the EA (QoQ, ar)
Note: “Total comp” stands for Labor Cost, total compensation, “W&S” stands for Labor Cost, Wages and Salaries, “CPH” stands for Hourly Compensation, ULC stands for Unit Labor Cost, “CPE” stands for Compensation per Employee, “Adv wages” stands for Advertised in Job Posting (YoY), “Negot wages” stands for Negotiated Wages (YoY). All figures are QoQ at annual rate, unless otherwise indicated.
Our forecast
Our model-based forecasts confirm that wage growth in the EA is set to be higher than in the US starting in the second quarter of 2023. We have updated our model-based forecasts of wage and total compensation growth for US and EA measures. Our results are shown in Figure 4 which reports the average across all measures in each quarter (“1 qt”) and over four quarters (“4 qt”). We estimate wage and total compensation in the US at 3.8% in 2022:Q4, as some measures have decelerated (notably Average Weekly Earnings). On the other hand, we estimate that in the EA wages have grown at 3.5% (ar) in 2022:Q4 with little dispersion across measures. Having said so, the central result of our analysis is that wage growth is expected to flatten in the US and remain close but below 4% by the end of 2023; on the other hand, wage growth is expected to accelerate in the EA and reach 4.5% at the end of this year (in line with the forward-looking wage tracker indicator of the Euro area which can be found in this January 2023 PPT of Philip Lane, slide 11). Ironically, in the December 2022 macroeconomic projections, the ECB staff expected ULC and CPE at 5.0% and 5.2% in 2023, respectively. Put it differently, it seems to us that the ECB staff has still to realize that the EA is way more similar to the US than assumed in the Bulletin.
Figure 4. Average across measures of wages and total compensation growth (%)
Note: The figure shows the average across measures of wage and total compensation growth. The thick lines (“4 qt”) show the average across all measures in the last 4 quarters. The thin dashed lines (“1 qt”) show the average across all measures in each quarter. The shadowed area indicates the forecast.
The risks around the ECB staff forecast (of both, wage and price inflation) are skewed to the upside. We expect core inflation to remain higher in EA than in US going forward. As previously communicated, our “main” Phillips curve model for the EA suggests that core HICP can remain above 3% throughout the entire medium-term. In fact, the models suggest that core inflation in the EA can average above US core CPI, unless a large recession hits. Nothing is written in stones, of course. The future can change, but the staff in Frankfurt needs to realize where the euro area is, especially compared to the US. This is not the time to be in “La La land”. It is the time to do what the Fed has done.