Doubts are being cast about whether inflation is more or less persistent, but least of all in the eurozone. This is not because energy costs will fall sooner here or the frictions between supply and demand will fade more quickly than elsewhere. The primary reason is that Europe has lost less of its workforce during the lockdowns than have other countries, notably the U.S., thanks to furlough schemes (see chart 1). Second, there are still untapped workforce reserves, which seem to be a little more easily mobilized than some years ago. It seems that the European labor market is more resilient and adjusts with fewer frictions to shocks than before. S&P Global Ratings therefore believes the European Central Bank certainly has more time than other central banks before it must counter wage inflation through rate hikes.

Chart 1

In the eurozone, the surge in inflation (4.9% over one year, 4.6% over two years if ignoring the lockdowns) is far from being broad-based. More than half is due to the rise in energy prices (27.4% over one year, 16.7% over two years), mainly caused by supply factors. Halt in the rise in oil prices, combined with tax cuts granted by many governments on gas and electricity bills from next year, will significantly slow inflation in 2022. Retail prices for gas matter, for sure, especially for the lowest-income households, but they are much more moderate than for market or wholesale prices and barely represent more than 2% of consumer spending on average (even less in the U.K). If, moreover, supply chain bottlenecks continue to gradually ease, so should the pressure on non-energy production prices (see "Eurozone Economic Outlook 2022: A Look Inside the Recovery," published Nov. 20, 2021).

It's too early to judge the impact of the new COVID-19 omicron variant on prices, and, in any case, they will likely vary over time. The omicron variant may speed up disinflation initially if it lowers demand for transportation fuels. Afterward, it can be inflationary if lockdowns again disrupt supply chains. This will depend how omicron develops, though not only in Europe.

We believe it's more important to gauge the inflation outlook beyond 2022, once the shock of the pandemic of 2020 has been absorbed, assuming that potential future waves of COVID-19 will continue to lose more and more of their grip on the economy. Typically, core inflation mostly depends on how much wages grow compared to productivity. The difference between the two is measured by growth in unit labor costs, which is now falling in most sectors. This allows European producers to absorb part of the increase in nonlabor production costs, a situation that is much different than in 2007 and 2008 when both wages and rising raw material prices squeezed margins (see chart 2). Moreover, the current fall in unit labor costs mirrors their rise in 2020, a pendulum swing that was in sync with the shutdown then sudden restart of economies, during which time employers kept most workers on their payrolls thanks to the furlough schemes--with wages paid by employers but subsidized by European governments.

Chart 2

These mechanisms allowed eurozone employment to recovery quickly and rather smoothly. Of the 5 million jobs wiped out in the spring 2020 lockdown, 4.7 million have already been recovered by the third quarter of 2021. In a few countries, for instance France, employment is already above its pre-pandemic level. The labor force participation rate also looks to be back to its pre-crisis level in the eurozone, in sync with GDP, while it is still 1.5 percentage points below in the U.S., even with a faster GDP recovery (a puzzle we addressed in "Where Are The Workers? Three Explanations Point To An Answer," published Nov. 4, 2021).

In the eurozone, the Beveridge curve--which illustrates the fact that job vacancies usually fall as the unemployment rate rises (and the other way round)--has not shifted to the right as it has in the U.S., a development that usually suggests a rise in the level of structural unemployment. The situation in Europe is not only in sharp contrast to the U.S. It also contrasts with previous reactions of the labor markets to previous crises: In the eurozone, the Beveridge curve shifted to the right in the aftermath of the financial crisis (2008-2009) and the debt crisis (2012-2013), and structural unemployment rose continuously. The European labor market seems to be much more resilient now, with the last point of the Beveridge curve firmly in the northwest quadrant (see chart 3). Some proof of that is in an Eurostat estimate for the EU-27: Only 2.7% of people who were employed in 2019 fell into inactivity in 2020, a share that is barely higher than before the pandemic.

Chart 3

This smooth recovery of the labor market in Europe is translating into moderate growth in wages. Negotiated wages are up 1.5% in 2021, compared with 1.9% the year before. But the rapid recovery in employment also means that Europe is again approaching the "full employment" situation where it was headed before COVID-19. The vacancy rate (2.5%) is at an all-time high, and an increasing share of companies are pointing to labor shortages as factor limiting their production. While we have learned to wary of such estimates, the unemployment rate in the eurozone is close to its structural level (7.6% in 2021, according to the OECD), warranting an acceleration of negotiated wages toward 2%-2.5% (see chart 4). This seems to be the range of wage increases currently under discussion by social partners and already agreed in Germany for next year. Even if the minimum wage in Germany is increased by 25% in 2022, as the government has proposed, this would only benefit about 2% of workers and must be seen in light of a wage increase of 1.9% in 2022 that German unions have already negotiated for about 14% of the country's workers (see table 1). Such increases are consistent with the S&P Global Ratings' survey of its corporate analysts, which expects wages to rise only "a little" next year (see "Global Corporates: Supply Chain Strains And Rising Costs Will Pressure Profitability In 2022," Nov. 18, 2021). Yet, the pace of wage increases remains below the productivity gains expected for 2022 (3.1%) and not much above the productivity gains expected for 2023 (1.5%). This suggests that wage inflation is not likely to show its head soon. That said, eyes will be on wage negotiations due to be held next year and thereafter for any updrift in wages—that is, actual compensation increasing more than negotiated wages.

Chart 4

On the other hand, unemployment data may be underestimating labor reserves, and it is not certain that the wage increases under discussion will go through. The migration of workers internationally and between EU countries, which stopped during lockdowns, is resuming. That could help to reduce the perceived shortage of labor. While the unemployment rate has returned to its pre-crisis level, this is not the case for a broader measure that currently stands at 15.5%, still a good point higher than it was in 2019. (The broader measure includes involuntary underemployment, people searching for a job but unavailable, or people available but not searching actively for a job.) Moreover, the European labor market seems to have become more flexible in the past few years. For example, the transition from unemployment to employment is easier today than it was five to 10 years ago, especially for women, for the same pace of GDP growth (see chart 5). Put another way, the reforms to the labor markets passed in many countries over the past decades might have increased their resilience and reduced their frictional adjustment to shocks—A topic that is worth exploring further.

To conclude, there is little chance that labor market conditions in Europe will contribute to a significant and sustainable acceleration in core inflation before 2023. The ECB certainly has more time than other central banks before it must counter wage inflation through rate hikes.

Chart 5