(Bloomberg) -- A key plank in the European Central Bank’s case for inflation returning to 2% faces growing skepticism — potentially damping hopes for sustained cuts in interest rates.
For consumer-price gains to retreat to the ECB’s target as envisaged late next year, an increase in productivity must accompany moderations in workers’ pay and company profit margins.
A more productive labor force would lower the cost per unit of output, exerting downward pressure on inflation, and has long been sought to help haul the euro zone out of stagnation. It’s proved elusive, though, and shocks from Covid to Russia’s war in Ukraine threaten to leave lasting scars on the 20-nation economy.
Should an adequate improvement fail to materialize, the projections underpinning the ECB’s policy stance could be in jeopardy. Analysts currently see officials resuming rate cuts in the fall after holding fire when they meet this week.
The focus “is increasingly on productivity,” according to Paul Hollingsworth, an economist at BNP Paribas in London who sees wage gains broadly in line with ECB expectations and profit margins compressing.
“The ECB relies quite a lot on productivity picking up to ease some of the unit labor cost pressures,” he said. “If that doesn’t happen – if it’s not just a cyclical downturn in productivity, but something that’s a bit more structural – that would have important implications for inflation as well.”
Some analysts say the ECB’s view that productivity will rise by about 1% in 2025 and in 2026 — faster than the 0.6% it averaged during the two decades before the pandemic — is too rosy, even after a downward revision in the latest forecast.
The measure fell by about 1% last year and by 0.6% in the first quarter. A popular explanation is that labor shortages prompted many firms to retain workers despite sluggish economic growth.
“The 2025 and 2026 staff projections still look too strong, and we still expect less disinflationary pressure from productivity growth than the ECB,” said Soeren Radde, an economist at Point72. “There remains an argument not to expect a deep cutting cycle.”
Officials will next set rates on Thursday, with economists unanimously predicting a hold at 3.75% after June’s initial reduction. The next meeting, in September, is viewed by markets as the likelier juncture to cut again as new economic forecasts will be available.
What Bloomberg Economics Says...
“Recent increases in compensation per employee, the ECB’s official time series on negotiated wages and services inflation have left the Governing Council reluctant to cut again without more data confirming that cost pressures are easing. That should cause it to keep rates steady in July, but slowdowns should help unlock another move in September.”
—David Powell, senior euro-area economist. Read the full preview here.
Policymakers understand the risks, according to an account of last month’s meeting. “Further evidence was required on both the extent to which unit profits would absorb the inflationary pressures from higher wages and whether productivity growth would rebound as expected,” it said.
The ECB’s most-recent projections acknowledge the extent of the uncertainty by calculating the impact of both more optimistic and pessimistic outcomes for productivity.
It’s also listed dangers like delays in benefits from digital technologies or a more negative impact than currently assumed from green policies, as well as the possibility of lingering effects of “past low demand” that reduce the need to boost output capacity.
Not everyone’s worried. For Bank of America economist Evelyn Herrmann, the ECB’s baseline is credible.
“There may certainly also be structural factors for low productivity, but we see it primarily as a cyclical phenomenon at the moment,” she said. “The ECB’s expectations for productivity development are not necessarily unrealistic and are consistent with what’s been observed in the past.”
And there’s no guarantee that the other factors officials are tracking will behave as expected. Wages continued to advance at an elevated clip at the start of the year as workers strive to offset the inflation shock. While the hope is that firms’ profit margins absorb these costs, like in the first quarter, the environment could yet shift once more.
“If economic activity picks up, companies’ pricing power is likely to increase again,” said Marco Wagner, an economist at Commerzbank. That “suggests a stronger price-driving effect of profits in coming years.”
But while any shift in the interplay between wages, profits and productivity risks derailing the outlook, it’s the katter that appears to be under the most scrutiny at the moment. Deutsche Bank said this week in a report that it’s less confident on that front than it is in the other two elements receding.
“What concerns me is the likelihood that we might have had some important structural changes that models struggle to catch and that inflation may be structurally higher than we think,” said Marco Valli, an economist at UniCredit in Milan. “If you’re getting one of these structural changes wrong, it would affect productivity, wages and profits — maybe all at the same time.”
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