Should the ECB be concerned about labour market dynamics and inflation breakevens?

Recent Euro area data have been moderately positive, albeit far from stellar: the Citi EA Economic surprises indicator has been broadly flat since mid-May. Probably the nicest recent upside surprise was the bounce in core HICP inflation from 0.8% to 1.0% in the flash July data, the highest since April 2014, beating market expectations of another 0.8% figure. But we will unfortunately have to wait until the full data on August 14th to discover its causes, assuming it’s not revised away.

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The final EA PMIs also brought limited positive news given that they were revised up a little from their flash estimates. But against that both manufacturing and services PMIs still fell on the month, suggesting slowing economic momentum. Moreover, the manufacturing PMI confirmed my suspicion that the tortuous route to the third Greek bailout has exerted a heavy economic cost.

The EC Economic Sentiment indicator (30 July) was on the surface more positive, given that it beat market expectations to rise to a 4-year high of 104.0: no slowing momentum apparent here. There are, however, interesting divergences underneath the surface. Specifically, while services confidence continued rising manufacturing confidence is flatling and consumer confidence has fallen back in recent months.

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Potential downside risk from labour market dynamics

The key question facing the EA is whether the growth dynamics can become more firmly entrenched, thereby supporting the ECB’s relatively optimistic inflation forecast. The June ECB forecasts anticipated headline HICP rising to 1.5% in 2016 and 1.8% in 2017, from the current 0.2%, with core HICP rising to 1.4% in 2016 and 1.7% in 2017.  I discussed the potential downside risks from the ECB potentially being too optimistic on lending dynamics here.

And one potential explanation for weak consumer confidence could be weak labour market dynamics. So is there also a risk that a weak labour market and consequently consumer confidence can hold back the broader recovery? After all the June ECB forecast documentation argued that “Private consumption expenditure is expected to remain a key driver of the recovery….wage income is expected to pick up against a background of steady employment growth and accelerating nominal compensation per employee.” And the ECB forecasts private consumption growth of 1.9% this year followed by 1.6% in both 2016 and 2017. With the effective tax cut (real income boost) to consumers from lower energy prices unlikely to be repeated (although end section) the baton to supporting consumption needs to pass successfully to the labour market.

Recent data provide several reasons to be cautious about EA labour market prospects, increasing the chances of the ECB’s APP being extended beyond September 2016.

First, EA employment remains sticky at relatively high levels (11.1%, versus 5.6% in the UK and 5.3% in the US) with high dispersion across EA countries. Spain is the poster child for falling unemployment, but there remains an awful lot of work to do with unemployment still at 22.5%. And unemployment doesn’t seem to be going anywhere fast in the “core” countries: German and French unemployment have been flat for three months and Italian unemployment has risen in the past two months.

Second, surveys do not point to any substantive improvement in labour market quantities, although to be fair to the ECB they only expect “steady employment growth” of 0.9% this year and next and 1.0% in 2017. Specifically, this morning’s final July PMI also reported the weakest jobs growth since February (with Italy and France underperforming). And the EC survey shows both companies and consumers getting less optimistic about employment prospects. Indeed, its hard to argue that any of the major EA economies’ industrial companies are particularly optimistic on employment. Even German expected employment ticked down and French expected employment is the weakest since January 2014.  And consumers’ greater concerns about unemployment are echoed in lower optimism about the general economic situation and making major purchases (in contrast to the spike in the UK equivalent). So overall probably not a particularly auspicious backdrop for decent-looking consumption (and this morning’s EA retail sales were surprisingly weak), even if the surveys haven’t fallen off the cliff.

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Third, earnings growth remains weak with most of the measures recently heading down. The data aren’t well publicised – they do not get the fanfare accorded to UK and US equivalents – probably because they are only quarterly (latest 2015 Q1), are a bit of a pain to dig out (most aren’t on Bloomberg) and there are several variants. But they nevertheless play the same role in the EA economy as they do in the US or the UK: it’s hard to get consistently-higher EA inflation without rising labour costs. And taken together they paint a picture of very restrained wages – perhaps unsurprisingly given the aforementioned labour market quantities. But again not much to give hope of supporting strong consumption, given that waning real income boost from lower energy prices.

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But a fourth point is that the EA Phillips Curve is quite flat: so wages are unlikely to rise sharply should labour market quantities improve. This likely reflects EA labour market rigidities, although the structural reforms which Draghi habitually encourages at ECB press conferences will eventually help here. But in the near-term those structural reforms may also put further downward pressure on wages, further inhibiting consumption growth.

ECB became less optimistic on earnings prospects, but inflation unchanged

To be fair to the ECB they already seem to be travelling in the direction suggested above. In particular, the June ECB forecasts they became less optimistic about compensation per employee and unit labour costs (revising both down by 0.3pp in both 2015 and 2016 relative to the March forecast). But my main point is that things don’t seem to have improved since June, indeed the fallback in employment expectations and consumer confidence suggests that prospects have deteriorated. So there could be further downward revisions, or at least greater downside risks incorporated, going forward.

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Moreover, delving into the June ECB forecasts reveals a couple of interesting things.

First, the ECB’s private consumption forecasts were unchanged despite the weaker compensation per employee forecast, an unchanged employment forecast and upward revisions to unemployment forecasts in 2016 and 2017. One potential explanation is that they’ve become more optimistic on non-labour income or easier financial conditions, although I can’t quantify that convenient coincidence from the ECB’s documentation.

Second, the 2016 and 2017 inflation forecasts were also unchanged despite the weaker unit labour costs forecast (which most models see as tying down medium term domestic inflation prospects). The ECB seems to have squared this circle by a combination of larger and more protracted impacts of the EUR depreciation (they note “the substantial lagged effects of exchange rate movements on inflation”) and higher corporate profit margins (they note “profit margins are seen to recover…as productivity picks up and economic activity strengthens, supporting the pricing power of corporations”). Again this seems potentially like a convenient coincidence – perhaps a way of squaring the Governing Council’s big picture inflation view with the staff data update – which probably deserves further analysis.

ECB taking positive view on oil recent price falls, but breakevens declining

My discussion above on the baton needing to pass from real income being supported by commodity price falls to labour income gains skirted over the issue of recent falls in commodity prices. The ECB have thus far adopted a positive view.  In particular, Draghi’s July ECB press conference statement argued that the recent oil price falls would support household real disposable income and corporate profitability (and hence consumption and investment). Draghi also argued that the ECB’s policy actions means that lower oil prices would not destabilise inflation expectations.

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And the 14bp fall in EA 5y5y breakevens since start-July has indeed been smaller than implied by previous links with oil.  It is also similar to the fall in US breakevens, but exceeds the 6bp fall in UK breakevens. But it could nevertheless start concerning the ECB given the relatively low level of EA breakevens (5y5y of 1.71% is approaching the end-May low-point) and actual HICP inflation. And we should not forget that the ECB has placed more policy weight on breakevens than the BoE or the Fed.  So, as per the analysis of labour market dynamics, this suggests not ruling out an extension of the ECB APP.

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