Markets & Finance

The Euro Zone: Wage Spike Ahead?


At last, some good news on Europe’s labor front. Unemployment in the euro zone -- the 12 countries that use the euro as their common currency -- may have bottomed out, and stronger economic growth should allow work prospects to improve.

But there could be a dark cloud to this silver lining. While these trends are positive for 2006 consumption growth and domestic demand, they also increase the risk of "second round" inflation effects -- i.e., the tendency for wage increases to help lift overall inflation. This is one reason why the European Central Bank remains on course for further rate hikes.

Among the encouraging signs for the labor market: The euro zone's harmonized unemployment rate remained steady at 8.3% in January. This is high by international standards but below the 8.8% registered in January, 2005. The overall number of unemployed declined for two consecutive months, and it seems as though the rate has finally topped as the labor market improves.

DATA DISTORTION. Italy produces unemployment data only with a time lag, but trends in Germany and France seem encouraging. German unemployment data remains affected by methodological and institutional changes, which has made data volatile and unreliable. But even the German labor market seems to be improving. Employment data from the European Central Bank, which are only available through the third quarter of last year, show moderate annual growth rates, and a deceleration in recent quarters.

However, this may again be partly influenced by German factors. German employment at the beginning of 2005 had been boosted by government efforts to promote the low-paid sector, which distorted the overall picture. The number of jobs subject to social security contributions actually continued to decline. This means that previous increases were overstated, and that recent developments are less disappointing.

Seasonally adjusted quarterly data show a rise of 0.3% in the third quarter mainly due to improvements in the services sector. This, along with better unemployment data, seems to confirm that the labor market has at least bottomed out.

CAUTIOUS APPROACH. Restrictive labor protection laws in many key euro zone countries mean companies tend to be cautious in taking on new staff in the early stages of a recovery. If growth turns out to be less strong than expected, it is difficult to lay off staff. So companies tend to increase working hours and overtime before considering new hires. There has been some improvement in recent years, but current developments in France highlight how difficult it is to increase flexibility on the labor market.

The French government has introduced a new contract that makes it easier for companies to fire young employees with little notice or compensation during the first couple of years of employment. The measure was rolled out in an effort to help cut youth unemployment but has sparked widespread student protests. Nevertheless, progress has been made in restructuring the labor market, and it seems governments are finally tackling the problem.

Indeed, the strong readings in surveys of purchasing managers for the the manufacturing and services sectors suggest that companies are thinking about taking on more staff. The employment reading in the manufacturing purchasing managers' index (PMI) remains below the 50-point "no change" mark, but sufficiently close to suggest stagnation, rather than real job cuts.

STRUCTURAL REFORMS. The employment reading in the services PMI is clearly above the 50-point mark, indicating job creation, and is continuing to improve. It seems the outlook for employment growth this year is encouraging. Governments' structural reforms may also bolster hiring growth.

An improved labor market also means, however, that there is more risk of second-round inflation effects. Employees are likely to seek compensation for previous cuts in real disposable income caused by the sharp rise in energy prices. So far, wage increases have been subdued as high unemployment rates undermined the bargaining power of unions in wage negotiations.

But with growth returning to trend, and labor markets improving, this is likely to change. Faster employment growth will be quick to contribute to demand-driven wage pressures in certain sectors.

LIMITED INCENTIVES. All in all, the euro zone labor market is improving in line with a gradual strengthening of growth. Some governments are trying to increase flexibility in order to reduce structural unemployment and improve employment prospects in the medium to long term.

However, still-generous social security systems in many countries mean that incentives to take up work are limited. Structural unemployment is very high, and the risk of second-round inflation effects via higher wage demands is building even in the early stages of recovery.

ECB President Jean-Claude Trichet has started to warn that while the central bank does not see signs of a price-wage spiral yet, it has to prevent this risk from materializing. So the improvement in the labor market is one of the reasons the ECB remains poised for further rate hikes. Two quarter-point moves this year seem increasingly likely, bringing the benchmark rate to 2.75%, with the next hike coming in June -- at the latest.


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