The European Central Bank is forecasting a sharp pick-up in core eurozone inflation from less than 1 per cent today to 1.8 per cent in 2020 – much closer to the bank’s 2 per cent target. But despite wage growth rising markedly, we think core inflation will remain subdued.

Annual wage growth across the currency zone has reached 2.3 per cent, compared with less than 1 per cent two years ago, and the central bank believes tightening in the labour market will be the catalyst for a 'relatively vigorous' rise in price inflation.

The fall in the eurozone jobless rate to 8.3 per cent helps explain the wage growth, but labour costs are only one driver of inflation. And the ECB targets price inflation, not wages: consumer price growth can stay in the doldrums despite pay increasing strongly.

Indeed, despite higher wage growth, two disinflationary forces are at play: the strong euro has cut import prices and companies have absorbed the higher labour costs, squeezing profit margins rather than raising prices for consumers.

While the euro has stabilised against the US dollar this year, it has risen further against other – especially emerging-market – currencies. The foreign-exchange drag may have passed its peak, but if the euro depreciation of 2014/15 enabled companies to use profits to build a cushion against the recent wage growth, they now have scope to allow the squeeze on their margins to continue.

At least some of the recent pick-up in wage growth could prove transitory. First, it partly reflects Italy’s annual wage inflation rising from 0.2 per cent to 3.1 per cent because of a 4 per cent increase in public-sector pay – but that includes a one-off payment to compensate for freezing wages since 2010 that is unlikely to be repeated.

More broadly, wage indexation in many countries means that as headline inflation rises, pay follows. Indeed, price-inflation is often a focal part of collective agreements, which cover 60 per cent of employees in the EU and up to 98 per cent in France.

However, the vast majority of the jump in headline inflation reflects higher energy prices. Once that effect drops out and headline inflation eases, upward pressure on contractual wages could fade, keeping inflation benign.

But even if tightening in the labour market is more enduring, we expect only slight rises in wage growth: after 1.6 per cent in 2017, we are forecasting 2.1 per cent for 2018, 2.2 per cent next year and 2.3 per cent in 2020. And that needn't necessarily lead to higher price inflation. Softer demand expectations and competitive pressures may deter firms from passing higher costs onto consumers through increased prices.

The Czech Republic, Hungary, Poland and Romania have seen wage growth boom over recent years in response to economic growth and tighter labour markets, but their core inflation rates remain below 2 per cent.

So until the end of 2020 we envisage just a single 0.15 percentage-point rise in the ECB’s deposit rate next September. And by then, the global rate cycle could be turning, led by rate cuts from the US Federal Reserve in September and December 2019, making prospects for ECB rate rises look even shakier.

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