Click here for Andrew Bosomworth's biography.

Look around and you might think that inflation in the Eurozone is about to rear its head. The economy grew at a stellar 3.6% annualised real rate in the fourth quarter of last year, fast enough for everyone to want their share of the pie, and some of Germany’s trade unions are indeed demanding hefty wage increases after years of restraint.

In this European Perspectives, we argue that consumer price inflation will remain in line with the ECB’s “close to but below 2 percent” objective and that in coming months it could decline well below that level, thanks to lower energy prices. Coupled with signs of slower economic growth in the United States and some disinflationary secular forces at work in the labour market, this calls into question the 4% repo rate the market expects this summer, and it has steepening implications for the slope of the yield curve.

All About Energy
Inflation in the months ahead will largely be influenced by developments in energy prices and labour costs. Concerning oil, the decline in the price of oil since 2006 will continue to reduce the headline rate of inflation. Looking further ahead, while several factors point to higher wage costs during 2007, our analysis suggests the increase will be small thanks to increased productivity and the disinflationary secular trends of increasing labour market flexibility and mobility.

After contributing up to a full percentage point to the rate of inflation at times during 2006, energy is now adding virtually nothing thanks to the declines in the prices of oil and natural gas and a rise in the euro’s exchange rate. As a result, both the overall rate of inflation and the rate excluding energy almost converged at 1.8% and 1.7%, respectively, in January this year.

In fact there is a very close relationship between the annual change in the euro price of oil and energy’s contribution to inflation. Our analysis suggests that a €10 decline in the price of oil from the previous year shaves 0.6% off the rate of inflation after three months.

The decline in the price of oil from an average of €54 per barrel during the first three quarters of 2006 to about €44 per barrel in February consequently helped reduce the headline rate of inflation from 2.5% late last year to just 1.8% in January. If oil were to stay at about current levels over coming months, and the underlying rate of inflation remain stable, this relationship suggests headline inflation could fall even further. These so-called base effects resulting from the decline in the price of oil could take headline inflation as low as 1.5% this summer.

Oil is not the only source of energy whose price is falling. Demand for natural gas and electricity has dropped off thanks to an unusually mild winter, causing a sharp fall in wholesale prices. The wholesale price for spot natural gas at time of writing in February was down 60% from a year ago to €9 per megawatt-hour and peakload electricity was down 55% to €37 per megawatt-hour. While utilities have not passed all those declines to consumers yet, reflected by higher retail prices in the Eurozone’s January inflation report for electricity, competition should help ensure that consumers’ heating bills benefit from the warmer weather.

What About Wages?
Several factors suggest that labour costs will rise this year and push consumer price inflation up. Companies’ profits have grown impressively with the economic expansion such that some trade unions, like Germany’s IG Metall, currently demand a 6.5% wage increase. The European Commission’s survey of businesses reveals that labour is increasingly a factor limiting production, an indication that skilled workers are in shortage. Finally, the Eurozone’s unemployment rate fell to 7.4%, the lowest rate since the monetary union was formed, and this year it looks set to fall below the so-called non-accelerating wage rate of unemployment (NAWRU), a situation that usually leads to rising pressure on wages. But will these developments really push inflation up? A closer look suggests they are valid inflation risks, however, we do not think they will lead to a marked increase in consumer price inflation.

Take Germany’s trade unions for starters. Three unions covering approximately 4.3 million workers in the chemicals, capital goods and construction sectors currently seek wage rises of about 6%, much higher than Germany’s 1.8% rate of inflation in 2006, and equivalent to about a 4% real wage increase after subtracting that inflation. In the past, however, employers and employees typically settled on wage increases at about half of the unions’ initial demands. Furthermore, labour productivity in Germany’s private industry rose 6.5% in the first half of 2006, and it averaged 3% in the decade prior to that. Wage rises are only inflationary if the real wage increase exceeds the rate of labour productivity. We think it is unlikely that Germany’s unions will secure real wage increases above even the long-term rate of labour productivity.

Risks remain. High wage settlements in Germany’s manufacturing sector could raise expectations for higher wages in less productive sectors like services, and less productive countries like Italy. Wage costs in the entire Eurozone were kept down in recent years thanks in part to wage restraint in Germany while in some other countries real wages rose above the rate of labour productivity. So if German workers secure real wage gains this year, workers in other countries will have to accept lower real wages to keep the overall wage bill unchanged.

What about the apparent shortage of skilled workers and prospect of the unemployment rate falling below the NAWRU? These are legitimate cyclical inflationary risks, but they have offsetting secular disinflationary factors that should limit upward pressure on wages.

Last year all of the old EU15 countries, except Germany and Austria, either eased or completely removed restrictions on the free movement of labour from the new EU10 countries. All restrictions to the movement of labour within the European Union have to be removed completely by 2011. This lowers the barrier to labour mobility and is crucial to easing pressure on labour markets, which will help cap wage increases over the long-term.

More stringent eligibility criteria for unemployment benefits in some countries also play a secular disinflationary role. This is best reflected in the flattening of the Eurozone’s Phillips Curve, where the rate of unemployment has fallen since 1998 without wage costs rising. Not only does this reflect wage moderation on behalf of employees, it also reflects the results of those policy changes designed to encourage employment. Germany, for example, reduced both the level and duration of unemployment benefits to create greater incentives for unemployment beneficiaries to reenter the workforce.

Putting it all together, we think unit labour costs will rise from about 1% now to about 1.75% by early 2008, due to the strength of the labour market and a late-cycle slowdown in productivity. Core inflation under this scenario should edge up from about 1.5% now, when factoring out the German VAT impact, to about 1.75% by early 2008. What happens to headline inflation will depend on energy, but it would take oil back over €54 per barrel to cause an inflation problem for the ECB.

Implications For The Curve
Bringing our benign short-term outlook for inflation together with those secular disinflationary forces, we think the ECB will go on hold for a considerable period of time after hiking to 3.75% this month, and we would call into question the need for rates above that level given signs of slower growth emerging in the U.S. economy. When the ECB shifted from hiking to going on hold in the past, the yield curve steepened in anticipation of the easing cycle. When the next easing cycle eventually occurs, possibly in early 2008, today’s flat yield curve will steepen again too.

Andrew Bosomworth
Executive Vice President