Wages continue to rein in pace of ECB rate cuts

Last month saw the European Central Bank (ECB) get their cutting cycle underway with a 25bp cut in the deposit rate to 3.75%. However, any expectations for a rapid series of reductions after the first move were tempered by President Christine Lagarde, who at the subsequent press conference was clear that the ECB could move in phases in which they left interest rates unchanged. Markets thus interpreted the June meeting as a “hawkish cut” that made a July cut unlikely, an interpretation we agree with.

While inflation in the Eurozone has generally been on a steady downward path since the peak in early 2023, June’s print showed a small pick-up with headline CPI at 2.6% year-on-year (versus 2.4% in May) and core CPI at 2.9% (2.7% in May). Progress on headline inflation has been pretty flat so far this year, while core inflation is roughly in line with the level most economists are expecting at year-end. Europe is not alone in having experienced slightly erratic inflation data in the first half of 2024, which highlights that there is still uncertainty as to when exactly inflation will get back to target.

The primary driver of the ECB’s caution on further rate cuts is wages, as we highlighted in May. Given the high correlation between wage growth and services CPI, as the chart below shows, the ECB’s ability (or willingness) to take rates lower, particularly in an improving growth backdrop, might be limited until further moderation in wage growth materialises. The ECB continues to expect progress on wages to be subdued in 2024 before a more meaningful decline towards pre-Covid trends in 2025. While most of the wage indicators from the ECB are yet to report second quarter data, monthly wage trackers continue to confirm the slow pace of decline. The Indeed wage tracker, for example, increased from 3.4% to 4.2% last month, reversing some of the declines of prior months, while the ECB’s own tracker of wage growth increased by 0.2% to 4.2% in May. 

Ultimately, wage growth is determined by the discussions between the employee and the employer. In Europe this often involves collective bargaining with unions, and in some sectors might only happen every couple of years. The pace of the decline in wage growth might therefore be slower in Europe relative to the US, where the labour market is more flexible; for the same reason, wage growth in Europe arrived a few quarters after it did in the US.

The forward-looking data does continue to point to a softening, which will most likely give the ECB enough confidence to cut, if only slowly. The ECB’s Survey on the Access to Finance of Enterprises (SAFE) for Q2 2024 showed a decline in wage expectations from around 6,000 small businesses surveyed. Selling prices are expected to increase by 3% over the next 12 months, down from 3.3% in the last survey, while wages are expected to increase by 3.3%, down from 3.8% (service sector wages are expected to increase by 3.6% vs. 3.1% for other sectors). A net 53% of respondents reported higher labour costs, down from 66% in the previous survey, helping reduce the percentage of firms that saw a deterioration in profits.

Looking at the implied path of monetary policy in Europe (using Euribor curves) out to 2027, we can see how the expected path of rates has shifted over the year. 

The short end is currently pricing in two cuts for the rest of the year (taking the deposit rate to 3.25%), with another three cuts in 2025 to take the terminal rate to just under 2.5%. That is versus just under 2% at the beginning of this year, but down from just under 2.7% at the beginning of this month, with the move in July largely led by the US. Ultimately, in the absence of a meaningful slowdown in growth or labour data, we think a 2.5% terminal rate is fair. That is around 100bp lower than the terminal rate currently projected for the US, but we will be keeping a close eye on how the data plays out in the coming months to see if anything changes that view.