Tight labour market fuelling inflation in Europe

Silvan Mifsud is director of Advisory at EMCS Tax & Advisory

In March 2023, we have seen that the overall headline eurozone inflation has dropped,  as expected,  but core inflation continues to rise. Headline inflation fell from 8.5% in February to 6.9% in March, but core inflation ticked up to 5.7% in a sign that the fight against inflation is not over.  This will mean that the European Central Bank will remain on its path of increasing interest rates.  

The March decline in headline inflation was widely expected due to the energy price developments, which spiked in March last year. Energy inflation fell from 13.7% to -0.9% in March, which is the first decline in energy inflation since February 2021. However,  bigger concerns remain around the other components of inflation.

This is where a lot more work needs to be done. Core inflation increased from 5.6% to 5.7% in March with services inflation increasing from 4.8% to 5% while goods inflation fell from 6.8% to 6.6%.

Food inflation, which has been the largest contributor to headline inflation in recent months, increased from 15% to 15.4%. This indicates that price pressures remain high for the moment, although this should improve in the coming months. Forward-looking data are starting to become less concerning from an inflation perspective though. Futures prices for energy look manageable, while producer prices for food have also come off their peaks. Transport costs and supply chain problems have eased substantially, which had led to manufacturers seeing a drop in selling price expectations.

So which inflation component remains worrying going forward? The main concern seems to be around wage developments. Wage growth has been rising and with unemployment still at a low of 6.6% in the eurozone area, the chances of there being upward pressure on wages remain. The main risk here is that this could be a somewhat stickier inflation component, especially on the services side of European economies.

So, while March 2023 has registered a significant drop in overall inflation, core inflation remains a concern for the ECB. The potential for core inflation to remain stickier, largely due to wage developments and a tight labour market, will be the main reason for the ECB to continue to hike interest rates in the near term. Unfortunately for policy makers at the ECB, core inflation is of somewhat a lagging indicator. It is however also consistent with wage growth in the region, which continues to increase. Wage rises reached a record annualised pace of 5.7% in the last three months of 2022. That could increase inflation in the medium term. Salary growth is a key measure for both the ECB,  because wage growth fuels inflation. It is unlikely that price pressures can ease more meaningfully until wage growth slows down. It will thus be of pivotal importance that wage growth is well managed in this delicate juncture as otherwise we risk ending up like a dog chasing its own tail.