Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / How Eurozone Labour Costs Are Splitting Core and Periphery
Transcript
- Lucas: There's a number in the latest Eurostat release that I think deserves more attention than it's getting. Unit labour costs in Germany rose at an annual rate of 4.2 percent in the first quarter of 2026. In Italy and Spain, the comparable figure was about 1.8 percent. Luna: That's a pretty wide gap. And it's not a one-quarter blip either, right? We've seen this divergence building for a while. Lucas: Exactly. Look at the two-year trend. Germany has been running above 3 percent unit labour cost growth since mid-2024. The periphery has been mostly below 2 percent. And the ECB's own wage tracker, which I looked at this morning, shows negotiated wage growth in Germany at 5.1 percent year-over-year for April, versus 2.8 percent for the euro area average. Luna: So what's driving that? Is it just the usual story of tight labour markets in Germany, or is there something structural happening in the sectors? Lucas: It's partly sectoral. German manufacturing is still scrambling for skilled workers—engineering, automotive suppliers, specialty chemicals. Those sectors have powerful unions and multi-year contracts that locked in big increases during the 2022-2023 energy shock catch-up. Meanwhile, the service sector in Germany is also seeing wage pressure from things like hospitality and logistics, but the manufacturing component is really the standout. Luna: And in the periphery, the story is different. Italy and Spain have higher unemployment, even if it's come down a lot. So labour has less bargaining power. Lucas: Right. The unemployment rate in Spain is still around 11 percent. In Germany it's 3.2 percent. That difference in slack translates directly into wage dynamics. But there's also a compositional effect: the periphery has a larger share of low-wage service employment, and those sectors haven't seen the same catch-up demands. Luna: So what does this mean for the ECB? They've been worried about services inflation running hot. If German labour costs are accelerating, that feeds into services prices eventually. Lucas: It complicates the picture enormously. The ECB's mandate is price stability for the whole euro area, but if core countries are overheating while periphery countries are still catching up, a one-size-fits-all interest rate is going to be wrong for someone. President Lagarde acknowledged as much at the June press conference—she said the Governing Council is watching 'the distribution of wage pressures across member states.' That's central banker speak for 'we have a problem.' Luna: And markets are voting with their feet. Look at the five-day ETF data we pulled earlier. The German ETF, EWG, is basically flat—up 0.4 percent. But the Italian ETF, EWI, is up 1.8 percent, and the Spanish one, EWP, is up 2.2 percent. Investors are pricing in that the periphery might benefit from relatively lower costs. Lucas: That's a really interesting signal. Lower unit labour costs mean better competitiveness for exports, and for domestic firms competing with imports. So you could argue that the labour cost divergence is actually supporting a rebalancing within the euro area—periphery countries becoming more attractive for investment. But it also risks a two-speed recovery that could test the political cohesion of the monetary union. Luna: Let's zoom in on one sector: manufacturing. Germany's manufacturing unit labour costs rose 5.5 percent year-over-year in Q1. For Italy, it was 2.1 percent. That's a huge gap for companies deciding where to locate production. Lucas: And it's showing up in trade data. German export growth has been sluggish—only 1.2 percent annualised in the first four months of 2026. Italian exports, by contrast, grew at 3.8 percent. Spain at 4.1 percent. Now, part of that is the product mix—Germany is more exposed to China slowdown and the auto transition. But cost competitiveness is definitely a factor. Luna: So is this a structural shift? Or could it reverse if the periphery tightens and Germany's wage growth moderates? Lucas: I think it's partly structural, partly cyclical. Structurally, Germany's demographic decline is accelerating. The working-age population peaked in 2015 and is now shrinking by about 150,000 a year. That puts permanent upward pressure on wages. The periphery has more favourable demographics—especially France and Ireland, but also Italy and Spain have seen less severe declines. So the labour supply constraint is real. Luna: But on the cyclical side, if the ECB cuts rates later this year as markets expect, that could boost domestic demand in the periphery, which might then push up their wages too. Lucas: Exactly. We could see convergence from above—periphery wage growth accelerating toward Germany's level. The ECB's own projections show euro area negotiated wage growth peaking around 4.5 percent in mid-2026 and then gradually easing. But the distribution matters. If the periphery catches up through faster growth rather than Germany slowing down, that's actually a healthy outcome. Luna: Let's talk about the policy implications. The ECB has a new tool—the Transmission Protection Instrument, or TPI. It's designed to buy bonds of countries whose yields spike unfairly. Do you think labour cost divergence could trigger that? Lucas: It's possible, but not likely in the near term. The TPI is meant for 'unwarranted, disorderly' spreads. Right now, the spread between Italian and German ten-year bonds is about 140 basis points. That's elevated but not crisis-level. And the market seems to be viewing the divergence as a competitiveness adjustment rather than a fiscal sustainability problem. But if the gap widens to, say, 200 basis points, the ECB would have to take notice. Luna: We should also mention the impact on corporate profits. German companies facing higher wage bills might see margin compression unless they can pass it through to prices. And if they can't, because of global competition, investment might shift. Lucas: We're already seeing some of that. Several German industrial firms have announced capacity expansions in Eastern Europe and even in Spain over the past year. Volkswagen's battery plant in Valencia is a well-known example. But there are smaller ones too—Siemens Energy expanding in Hungary, BASF looking at sites in Belgium and the Netherlands because German labour costs are becoming prohibitive. Luna: So the labour cost story is really an investment story. And it ties into the broader theme of European competitiveness that we've touched on in previous episodes. Lucas: It does. And I think the key takeaway for listeners is that the next twelve months will tell us whether this divergence is a temporary feature of the post-pandemic recovery or a permanent shift in the euro area's economic geography. If it's permanent, we might look back and see 2026 as the year the core-periphery gap began to close—not through crisis, but through relative cost adjustment. Luna: Speaking of making sense of the economy, if walking through these numbers with us has made something click, I hope you'll consider supporting the show. It's what keeps it ad-free and independent. Lucas: Yeah, listener support really does make a difference for us. If you're able, you can throw a few dollars our way at buy me a coffee dot com slash fexingo. No pressure, just a sincere thanks to those who do. Luna: Alright, back to the data. One more angle I want to get into: the services sector. Because services inflation is still the ECB's main headache. Lucas: Right. Services unit labour costs across the euro area rose 3.8 percent year-over-year in Q1. That's down from 4.2 percent in Q4 2025, but still well above the 2 percent level that would be consistent with the ECB's inflation target. And here the divergence is less extreme—Germany's services ULC is 4.1 percent, Italy's is 3.2 percent, Spain's is 3.0 percent. So the gap is smaller than in manufacturing. Luna: Because services are less tradeable. You can't offshore a haircut or a restaurant meal. So wage pressures in services tend to be more localised and more persistent. Lucas: Exactly. And that's why the ECB is so focused on services inflation. It's the stickiest component. If labour costs in services remain elevated, the ECB can't declare victory on inflation even if goods prices are stable. And with German services wages still accelerating, the risk is that the 'last mile' of disinflation takes longer than expected. Luna: So what's the one number you're watching over the next quarter? Lucas: The ECB's negotiated wage growth data for Q2, due out in August. If that shows German wage growth starting to moderate—say, below 4.5 percent—then the peak is behind us, and the divergence might narrow from the top. If it stays above 5 percent, the ECB will have a hard time cutting rates in September. Luna: And for the periphery, the number to watch is unit labour cost growth relative to productivity. If productivity picks up, they can absorb higher wages without fueling inflation. Lucas: That's the silver lining. Spain and Italy have both seen productivity improvements in manufacturing, partly thanks to digitalisation and reshoring trends. If that continues, the labour cost divergence could be a feature, not a bug—a sign that the euro area is rebalancing in a healthy way. Luna: We'll be watching those numbers closely. Thanks for joining us on The European Economy Podcast. Lucas: Until next time.