Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Wage-Price Spiral
Transcript
- Lucas: So there's a phrase that keeps popping up in central bank speeches this year, and it's one of those terms that sounds scarier than it maybe is — but also maybe isn't scary enough. Luna: Let me guess — wage-price spiral? Lucas: Exactly. And I want to look at this through a very specific lens: the German public-sector wage deal that was finalized back in April. That's the concrete case that a lot of ECB watchers have been pointing to as a potential canary. Luna: Remind me what the numbers were. I remember it being a big number. Lucas: The Verdi union and the employers agreed to an 8.5 percent wage increase, phased over 24 months, plus a tax-free inflation bonus. For context, that's roughly double the rate of negotiated wage growth we were seeing in Germany two years ago. And it covers about 2.5 million public-sector workers. Luna: So when you hear 'wage-price spiral', the image is that wage increases push up prices, which then justify further wage demands, and you get this self-reinforcing loop. Is that what the ECB thinks is happening? Lucas: Not uniformly, but there's clearly concern. Christine Lagarde mentioned the wage-price spiral risk explicitly in her June press conference, which got people's attention. She said — and I'm paraphrasing — that the pass-through of wage costs to prices, especially in services, is the single biggest upside risk to the inflation outlook right now. Luna: And the data backs that up. The euro-area negotiated wage indicator for Q1 2026 came in at 4.5 percent year-over-year. That's down from the 5.2 percent peak in late 2024, but it's still way above what the ECB considers consistent with its 2 percent inflation target. Lucas: Right, because if you do the rough math — wage growth of 4.5 percent, combined with productivity growth that's been hovering around 0.5 percent in the eurozone — unit labor costs are rising at about 4 percent. That's hard to square with 2 percent inflation unless corporate margins compress significantly. Luna: And that's the key tension. The ECB's baseline forecast assumes that firms absorb some of those higher labor costs in their margins. But if companies decide they have pricing power — which, given the services sector, they often do — then wage inflation becomes price inflation. Lucas: Let's go back to the German public-sector deal specifically, because what's interesting is the sectoral spillover. Germany's private-sector unions typically look at public-sector settlements as a benchmark. The IG Metall negotiations in the manufacturing sector are coming up later this year, and if they use 8.5 percent as a reference point, that's where the spiral risk gets real. Luna: Manufacturing is a different beast though, right? Because there's global competition, productivity is higher, and companies have more ability to automate or relocate. The pass-through from wages to prices is weaker there than in services like hospitality, healthcare, or retail. Lucas: So the ECB's concern is really concentrated in services inflation, which has been sticky around 4 percent. And if you look at the decomposition of services inflation, a big chunk is labor-intensive sectors like restaurants, hairdressers, and personal services. Those businesses can't easily replace workers with machines, and they operate on thin margins, so wage increases go straight into prices. Luna: There's also a forward-looking indicator I've been watching: the Indeed wage tracker for the eurozone. It shows posted wage growth still running at about 3.8 percent. That's down from its peak but not decelerating as fast as the ECB had hoped. Lucas: And that's the thing — the ECB is in a tricky spot. They've already cut rates twice this year, bringing the deposit rate to 3.25 percent. But if wage data doesn't cooperate, they may have to pause or even reverse. The market is currently pricing one more cut by year-end, but that's very conditional on the wage-price spiral not materializing. Luna: So what would a real wage-price spiral look like in the data? I mean, we have the 1970s as a historical analog, but it's not a perfect comparison because we had oil shocks and indexation clauses that don't exist today. Lucas: Right, the automatic cost of living adjustments that were common in the 70s — where wages were mechanically indexed to CPI — those are largely gone. What we have now is more informal linkage. Unions see inflation is still above target, they demand catch-up raises, and if those raises are large enough, they become a new cost-push factor. Luna: So it's more of a second-round effect than a spiral, strictly speaking. Lucas: Exactly. The ECB's language has actually shifted from 'wage-price spiral' to 'second-round effects' in recent months, which I think is a deliberate recalibration. They don't want to talk themselves into a narrative that becomes self-fulfilling. But the underlying concern is the same: if wage growth stays above 4 percent for another year, getting inflation sustainably to 2 percent is going to be very difficult. Luna: Let's talk about the other side — the argument that the wage-price spiral is overblown. Some economists, like those at the Bruegel think tank, argue that corporate profit margins expanded significantly during the post-pandemic inflation, and that there's room for margins to compress without causing a recession or a wage-price spiral. Lucas: That's a fair point. Eurozone corporate profit margins are still above pre-pandemic averages, especially in services. So if we see margins mean-reverting, that could absorb a lot of the wage pressure. The question is whether companies will allow that to happen voluntarily or whether it takes weak demand — and therefore higher unemployment — to force margin compression. Luna: And that's where the output gap comes in. The ECB's own estimates suggest the eurozone output gap is roughly closed, maybe slightly positive. If the economy is at or above potential, then firms have more pricing power, and wages get passed through more easily. If growth slows, the opposite happens. Lucas: So the near-term outlook hinges on the growth-inflation trade-off. And frankly, the data in July 2026 is mixed. The composite PMI for the eurozone has been hovering around 51 — barely expansionary. Industrial production is weak. But the labor market remains very tight, with the unemployment rate at a historic low of 6.3 percent. Luna: Tight labor market plus sticky services inflation — that's the classic recipe for second-round effects. And yet, the ECB seems to be betting that it won't spiral. Why? What's their counterargument? Lucas: I think their core argument is that inflation expectations remain anchored. The ECB's Survey of Professional Forecasters shows long-term inflation expectations at 2.1 percent. As long as people and businesses believe the ECB will act to keep inflation in check, they won't build wage demands that assume 3 percent inflation forever. And that anchors the spiral before it starts. Luna: But expectations can become unanchored if inflation stays above target long enough. We saw that in the US in the early 1980s. It took a severe recession to break the spiral. Lucas: That's the nightmare scenario, and it's why the ECB is being so cautious. They'd rather keep rates higher for longer than risk having to do a Volcker-style crackdown later. Lagarde said as much in her last press conference — she said the last mile of disinflation is the hardest, and that's where the wage-price spiral risk is most acute. Luna: Alright, so let's zoom back to that German deal. What's the latest? Has the implementation started? Because the deal was signed in April, but the wage increases are staged. Lucas: The first tranche — a $1,300 tax-free bonus — was paid out in May. The first actual wage increase of about 4.5 percent took effect in June. So we're only now starting to see the impact on actual payroll data. The second tranche, another 4 percent, kicks in next April. Luna: So the inflationary impulse from this deal hasn't even fully fed through yet. That means the Q3 and Q4 inflation data could show a bump from this wage increase, even if the overall trend is downward. Lucas: Exactly. And that's why the ECB isn't declaring victory yet. They need to see actual wage data for Q2 and Q3 before they can be confident that the pass-through is benign. The next negotiated wage data release is in August, and it's going to be closely watched. Luna: It's fascinating how one sectoral deal in one country can become a bellwether for the entire eurozone monetary policy outlook. That's the kind of specific thing that makes economics real. Lucas: Speaking of things that make things real — if walking through the wage-price spiral with us has made something click for you today, there's a link that helps keep this show ad-free and independent. It's buy me a coffee dot com slash fexingo. Luna: Yeah, honestly, it's the smallest possible ask. If today's episode was worth a coffee to you, that's the link. And it genuinely makes a difference for a show like this. Lucas: So back to the wage-price spiral question — let's connect it to something listeners can watch for. If you want to track whether the spiral is materializing, don't just look at headline wage numbers. Look at unit labor costs relative to selling prices. If unit labor costs are rising faster than producer prices, that means margins are compressing, which is actually good news for inflation. Luna: But if both are rising in tandem, that's the sign of pass-through happening. The ECB will be watching the producer services price index especially, because that captures the cost of services businesses buying services — which is very labor-intensive. Lucas: And the other indicator is inflation expectations in the services sector. The European Commission's survey asks services firms about their selling price expectations for the next three months. That number has been coming down but is still elevated. If it starts to rise again, that's a red flag. Luna: So what's your bottom line? Are we heading into a wage-price spiral, or is this a story that fizzles out? Lucas: I think the most likely outcome is that we get a prolonged period of slightly sticky services inflation, but not a true spiral. The structural forces that create spirals — indexation, low central bank credibility, commodity shocks — aren't really present today. But I also think the risk is higher than the market is pricing. The market seems to assume the ECB can cut rates unimpeded, and I'm not sure that's the base case. Luna: So more of a slow burn than a firestorm. Lucas: Exactly. And that slow burn is still painful for households and businesses. But it's not 1973. And for central bankers, that distinction matters — because you don't need a sledgehammer if the problem is a slow leak.