Subdued wage growth in euro area likely to keep core inflation low

In the past two years, unit labor cost growth in the euro area has been subdued and is expected to remain one of the main reasons for weak core inflation in the currency bloc, stated Societe Generale in a research note. Economic theory implies that a solid pass-through between core prices and unit labor costs (ULC), and minor rise in ULC is a major assumption in the projection of a very slow rebound in core inflation in the medium term, noted Societe Generale.

Lately, labor markets in the currency bloc have been rebounding, albeit at slower rate along with pro-cyclical gains in productivity, while wage growth is weak. In the first quarter of 2016, unit labor costs came in at 0.9 percent year-on-year, quite below long-term average of 1.6 percent.

“In our baseline scenario, we expect ULC growth to bottom out by the end of 2016, followed by a minor acceleration to 0.8-1.3 percent yoy over the medium term,” added Societe Generale.

But, this anticipated expansion might be considerably lower than the rate seen in the past economic cycles. For instance, compensation growth averaged 2.4 percent in the period of 2001-2007. There might be threat to this assumption if long-term inflation expectations continue to be low and a rise in wages is unsuccessful in materializing or is delayed. This would then be a drag on unit labor cost growth and therefore might lead to additional deterioration of core inflation outlook in the medium-term.

Hence, given the developments in unit labor costs and the usual lag between core inflation and ULC, core HICP inflation in the euro area is likely to rebound just slightly from the present 0.9 percent year-on-year to average 1 percent this year and 1.2 percent year-on-year over 2017-2020, according to Societe Generale.