Euro Zone: The Perils of Rising Labor Costs

A rising euro and cheaper energy are easing price pressures in the euro zone. But that could be short-lived. Labor costs are outpacing inflation, and the latest round of union wage agreements is set to keep upward pressure on business costs and slow an already fragile recovery.

In the first quarter, labor costs in the euro zone rose by 3.9% from the year before, up from their 3.4% gain in the first quarter of 2001. Broken down, wage growth jumped 4.1%, while the cost of benefits and taxes rose 3.1%. The acceleration in euro-zone wages is in contrast with trends in the U.S., where compensation growth is stalling.

And labor costs won't ease anytime soon: Wage agreements this year in Italy and Spain have exceeded 2%, while German unions won immediate lump sum payments of up to 210 euros ($207) per worker, along with pay raises of 3% to 4% for this year and 2003.

The pay gains have yet to spur consumer spending. Monthly retail sales for the euro zone unexpectedly slipped 0.6% in April. And the European Commission's June consumer confidence index fell to -9, from -8 in May.

Meanwhile, the factory sector's nascent recovery is weak. Manufacturing activity expanded for a third straight month, rising to 51.8% in June. Still, manufacturers trimmed payrolls, and input costs rose at the fastest clip since January, 2001. Factories are facing a squeeze. The 11% jump in the euro so far this year is making imports more price competitive and hurting exports. Unlike service-producers, manufacturers hold little pricing power. With few options at hand, factories will most likely cut more jobs.

Rising labor costs, as well as the weak industrial sector, put the European Central Bank in a bind. Even as June consumer prices are expected to dip below the 2% target set by the ECB, the bank continues to see considerable upward pressure on prices. The ECB meets again in September, but an interest-rate hike then could still be too early.

By James Mehring in New York

Before it's here, it's on the Bloomberg Terminal.