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Europe's Wage Watch

Pay hike, then a rate hike? The European Central Bank is eyeing upcoming labor talks in Germany amid concerns that big raises could spark inflation

The European Central Bank continues to trumpet its hawkish stance on inflation as 2006 draws to a close. Chairman Jean-Claude Trichet said in a Dec. 20 press interview that the central bank will do "whatever is necessary to ensure price stability." The ECB maintained its tightening bias after the last rate hike in December, even though it remains non-committal about the timing of the next move.

Nonetheless, the ECB's hand may be forced in the next few months. One of the key risks for inflation, apart from a renewed rise in energy prices, is the upcoming wage round in Germany, where there are signs that unions will call for a marked pay rise in light of stronger than expected growth. This will support arguments for another rate hike in the first half of next year.

The ECB warns in its December monthly report that "given the favorable momentum of real gross domestic product growth observed over the past few quarters and the positive signs from labor markets, wage developments could be stronger than currently expected." It therefore called on companies, governments, and unions to act responsibly and argues that wage agreements should not only take productivity growth into account, but also still high unemployment.

Union Requests

To be sure, unemployment in the eurozone—the economic grouping of countries that share the euro as their common currency—has come down substantially over the past two years. Capacity utilization rates have been rising markedly since the second half of last year and companies have started to take on more staff. However, the 7.8% jobless rate remains relatively high by international standards. And the big problem is a high level of structural unemployment in the eurozone. This means that the labor market is getting tighter, even though jobless rates remain high on paper.

Employment growth was also facilitated by relatively moderate wage increases in recent years. But there is now a distinct risk that in the light of relatively robust profit growth and rising employment, unions will start to call for stepped-up wage increases. The ECB argues that "wage agreements should take into account productivity developments in connection with the still high level of unemployment and positions in price competitiveness." This is very likely a warning to German unions ahead of the 2007 wage round.

The German recovery has benefited from very moderate wage growth in recent years. Data from the nation's central bank, the Bundesbank, show that gross wages and salaries actually declined 0.3% on average last year. There has been a pickup in the first three quarters of this year and gross wages rose 1.5% year-over-year in the third quarter, up from 1.3% in the second and vs. a rate of just 0.2% in the first.

Room for an Increase

However, with productivity also improving, unit labor costs were still down 0.8% year-over-year in the third quarter, according to Bundesbank data. Data from the EU's statistical service, Eurostat, look slightly higher but still show that Germany has the lowest increase in unit labor costs in the eurozone.

This could change, however, in the upcoming wage round. The focus here is on Germany's most powerful union—the IG Metall—which will present wage demands in February. The union has argued that hourly labor costs in the sector rose only 2.7% this year, while productivity growth is estimated at 7.1% year-over-year, which would point to a sharp decline in unit labor costs of 4.2%. In the eyes of the union, this means there is considerable room for wage increases now. For 2007 the union expects overall inflation of 2.3% and productivity gains in the sector of 4.5%, slightly above the 4.1% year-over-year expected for the economy as a whole.

So far, unions have not revealed any official negotiating points, but there has been talk of wage-increase demands of up to 7%, which would certainly square with the baseline assumptions of 2.3% inflation and 4.5% productivity growth. It is worth keeping in mind that wage demands are persistently considerably higher than final deals. However, high demands in the industrial sector, which is indeed registering above-average productivity growth, will have a signaling effect for unions in other sectors, where productivity demand is not that high.

Rising Corporate Profits

Also, the inflation forecast is relatively high and headline inflation in any case is still affected by higher energy prices, which should be seen as a temporary factor rather than something to be taken into account in wage demands. With non-wage labor costs also rising and employees facing a renewed upturn in health-care contributions next year, there is certainly pressure on unions to recoup some of the loss in purchasing power suffered in recent years.

And with corporate profits rising markedly this year and growth optimism spreading, public opinion also seems to be backing union demands for higher wage growth. This, together with the rise in capacity utilization and the gradual tightening of labor markets, clearly means that the union's bargaining power is much higher than it has been in recent years.

IG Metall chief Jurgen Peters will release a recommendation for wage demands on Feb. 6, which will be adopted on Feb. 26. Previous wage agreements end on March 31 and talks have to begin by March 17. Strikes are possible from April 28, and the signs do seem to point to a confrontational wage round with a clear risk of a marked rise in wages next year.

Previous Warnings

Trichet & Co. will be following the proceedings closely. High wage growth will not only push up inflation but, in the long run, will also undermine employment and overall GDP growth in the largest eurozone economy. There are transitional periods restricting the movement of labor for new EU members, but companies have long started to relocate to the new member states to make use of lower labor costs. This means high wage deals in Germany will only restrain employment growth in the long run.

In the short run, fatter wages will push up inflation and thus become an issue for the central bank, which has been warning for a long time of second-round inflation effects from previous energy price increases via higher wage demands. Apart from high wage rounds, the central bank also has to deal with the fact that in Spain, for example, around 81% of labor deals still contain clauses that automatically adjust wage growth to inflation. This means high oil prices in recent years are already reflected in wage growth, and thus cause second-round effects.

For now, wage growth has been relatively modest in the eurozone, which allowed the ECB to keep rates at a relatively low level. In Action Economics' view, it is very likely that unions will successfully push through high wage demands in Germany and elsewhere. This would confirm that medium-term inflation pressures are building up and thus support arguments for further rate hikes from the ECB. We continue to see another rate hike from the ECB in the first half of 2007, probably in March.

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