European Economic & Investment Outlook 2024

DOWNSIDE TO RISK INFLATION

WAGE GROWTH

FISCAL POLICY

in a decrease in firms' profit margins. As such this could prompt firms to explore cost-cutting measures, such as reducing their workforce. At present, wage growth is at 4.4% in the euro area (Q2 2023) and 8.5% in the UK (Q3 2023). To maintain inflation within the desired range of 2%, we require wage growth to be around 3%. While there is currently no evidence of a wage price spiral across the continent, there are lingering risks of its emergence, and central banks are vigilant about this possibility. It will be crucial to observe whether wage growth moderates in the coming quarters, as the absence of such moderation could pose risks for a shift towards tighter policy or an enduring higher-for-longer stance. The UK stands out as having a higher risk in this regard compared to the broader euro area, and a few specific countries (Czech Republic, Spain, and the Netherlands) also exhibit uncomfortably high wage pressures.

A key concern for central banks is the potential emergence of a wage-price spiral, which could result in sustained higher inflation and risk de anchoring inflation expectations. The probability of a wage-price spiral taking place hinges on specific macroeconomic circumstances. Typically, when labour demand is greater than the supply of labour, it increases workers' negotiation leverage. Due to the retrospective nature of wage agreements, wage growth is barely keeping pace with past inflation. In the euro area, wages are more responsive to historical inflation levels instead of labour market slack.² Since the pandemic, the disparities between demand and supply have pushed firms to increase prices, which has led to an expansion of profit margins. Looking ahead, as demand moderates, firms will find it more difficult to pass along increased costs, including higher labour costs, to consumers. Thus, the expectation is for firms to pare down their profit margins, reinforcing disinflationary dynamics. Indeed, there is a potential risk of a sustained decline in demand, which could result

Fiscal policy is another tool that can help (or harm) in the fight against inflation. Currently, fiscal policy is exerting opposing pressures, prompting numerous ECB officials to express their apprehensions that fiscal measures are ‘out of tune’ and may need to be scaled back to avoid potential medium-term inflationary pressures. Under the European Commission's updated economic regulations², member states with a deficit exceeding 3% of GDP are now mandated to reduce their budget deficit by a minimum of 0.5% of GDP per year.

France, Belgium, Hungary, Italy, and the UK have the highest budget deficits (ranging from 2-4 times the acceptable deficit). France, which has lagged behind other EU member states in deficit reduction, declared additional public spending reductions (€1 billion on top of the existing €16 billion). This move was attributed to mounting pressure on government debt caused by increasing bond yields. ² Commission proposes new economic governance rules fit for the future

THE TIDE IS TURNING TIME TO LIFT THE ANCHOR | 11

10 | ECONOMIC OUTLOOK 2024