Feb 26 / Alef Dias

Macroeconomics Weekly Report - 2024 02 27

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Labor market will guide ECB's next steps

  • The European Central Bank has linked the timing of its first interest rate cut to wage data. The discussion of wages in the minutes of the last Governing Council meeting suggests that these figures are unlikely to prevent a cut in June.
  • Unemployment is the lowest it has been in 40 years and the slack created by those on the margins of the labor market is modest. Looking ahead, this growth is expected to slow down as workers soften their demands for higher wages in the face of lower inflation.
  • Eurozone core inflation is likely to have fallen again in February, despite some upward pressure from energy prices. The core reading, in particular, is likely to have fallen quite a bit, as services inflation starts to fall again after three months of stagnation.
  • As a result, the ECB is likely to cut rates at the same time as the Fed. Consequently, there isn't much upside for the euro from the point of view of the yield differential.

Introduction

The last few weeks have brought important data for the Eurozone economy and for the next steps in the ECB's (European Central Bank) monetary policy, and next Friday the February inflation data will be released. Given these new fundamentals, we will update our outlook for the European economy and the Euro.

Minutes suggest cut is near, despite high wage growth

The European Central Bank has linked the timing of its first interest rate cut to wage data. The discussion of wages in the minutes of the Governing Council meeting on January 24 and 25 suggests that these figures are unlikely to prevent a cut in June. We believe that the various measures of wage growth will have slowed sufficiently by then to allow the ECB to make the move.

The ECB's chief economist - Philip Lane - was encouraged by the latest data. "The pace of wage growth remained high, but there were some early signs of a slowdown," said the economist. The dovish contingent tried to downplay the importance of high wage growth. "It was pointed out that nominal wage growth of around 5%... was not necessarily an excessive figure during a 'recovery' phase, bearing in mind that real wages had fallen by around 7% since the start of the bout of inflation.”

However, caution is still needed. "The gap between current wage growth of around 5% and a trend increase of 3% or 2.5% consistent with the 2% inflation target... was considered to be quite significant and likely to narrow only gradually over time," the minutes added.
The minutes also indicated optimism about the pace of inflation deceleration. "Inflation was moving towards the 2% target, possibly at a faster pace than previously expected," said Lane.

Image 1: EU - Basic and core inflation (%)

Source: Refinitiv

Tight labor market keeps ECB's focus on wage growth

Given the ECB's signal that wage dynamics are an important driver of monetary policy, it's important to understand the outlook for the European labor market.

The rigidity of the eurozone's labor market worries the European Central Bank and has been one of its main justifications for raising interest rates. Unemployment is the lowest it has been in 40 years and the slack created by those on the margins of the labor market is modest. Furthermore, job vacancies, as well as survey data, indicate that it is difficult to find new hires, although there have been some signs that a turning point has been reached.

Although the increase in the participation rate has reduced inflationary pressures, the tight labor market is still translating into high wage growth. Looking ahead, this growth is expected to slow as workers soften their demands for higher wages in the face of lower inflation. This should allow the Governing Council to cut interest rates in June.


Image 2: EU - Nominal wages (YoY)

Source: Bloomberg

Image 3: Unemployment Rate (%)

Source: Refinitiv

Inflation probably continued to slow down in February

Eurozone core inflation is likely to have fallen again in February, despite some upward pressure from energy prices. The core reading, in particular, is likely to have fallen quite a bit, as services inflation begins to fall again after three months of stagnation. Market estimates point to core inflation falling to 2.6% in February, from 2.8% in January. The core reading should have fallen a little more, from 3.3% to 2.9%.

Weekly figures published by the European Commission suggest that road fuel costs may have risen by around 2.5% in the month on average in the euro zone, in the wake of higher global oil prices.

These upward pressures from energy should be more than offset by a decline in contributions from other categories. Food and non-energy industrial product inflation is likely to decline further, as the exceptional price gains seen in late 2022 and early 2023 continue to fall year-on-year.

In Summary

Despite the slowdown in European inflation, which should continue with the data to be released this week, the still tight labor market should prevent an interest rate cut at the next meetings. However, estimates point to a slowdown in wage gains, which is supported by an increase in the participation rate - which should allow for a cut from June onwards.

As a result, the ECB is likely to cut rates at the same time as the Fed. Consequently, there isn't much upside for the euro from the point of view of the yield differential. The resilience of American economic activity also favors the dollar.


Image 4: 2-year yield spread (EU vs. US)

Source: Refinitiv

Weekly Report — Macro

Written by Alef Dias
alef.dias@hedgepointglobal.com
Reviewed by Pedro Schicchi
pedro.schicchi@hedgepointglobal.com
www.hedgepointglobal.com

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