ECB Monitor: Data in the Driver’s Seat

Summary

• Following the cut at their last meeting, ECB speakers mostly agree they are now in cautious data-watching mode.
• We assess the current data picture across services inflation, wage growth and unit profits.
• Inflation is trending back towards normality, but services continue to overshoot.
• Wage growth remains too strong, although evidence of whether this will feed inflation is mixed.
• Shrinking corporate profits are currently capping the feedthrough to inflation.
• But if unemployment continues to decline, it could become an issue on both the cost-pressure and demand side.

Market Implications

• There are hawkish and dovish risks ahead; we see modest room for more easing than currently priced (two more cuts in 2024).
• EUR 10Y swap rate is surprisingly suppressed given pricing for inflation swaps.

ECB in Data Watching Mode

Following the cut at their last meeting, ECB speakers have rallied around several distinct themes (see end section for a full breakdown of all speaker comments):

• Rates must stay restrictive for now.
• They are not declaring victory on inflation.
• They are in ‘data-watching’ mode, particularly:
  • Services inflation
  • Wage growth
  • Unit profits
• Every meeting is ‘live’, and there is no ‘pre-determined path’ for rates – a July cut is unlikely; September is more likely.
• They are happy to diverge from the Fed.
• French bond selling has not been disorderly (we are bearish French bonds here).

Based on the data, our conclusions are (more analysis below):

• Inflation is trending back towards normality, but services inflation continues to overshoot, wage-intensive services inflation has picked up recently (like in the UK).
• Wage growth remains too strong, although there is mixed evidence of whether this will feed inflation.
• Corporate profits are shrinking, suggesting some absorption within the margins.
• If unemployment continues to decline it could become an issue on the cost-pressure and demand side.

On the hawkish side: the shrinking profit margins are only necessitated while demand remains restricted. Unemployment continues to decline in Europe, which should gradually support demand. Meanwhile, upside risks remain from fiscal policy.

On the dovish side: real rates remain high, and if services inflation momentum fades, disinflation can resume. Meanwhile, a hawkish Fed will tighten monetary policy further, which could require the ECB to ease conditions more than otherwise.

Inflation Remains Strong in Services

Eurozone inflation dynamics are not too dissimilar from UK ones. Both headline and core inflation continue to drop, but services inflation is stubbornly high in H1 2024 (Chart 1). Looking deeper at the momentum in wage-intensive sectors, the comparison to UK inflation is even more obvious (Chart 2).

The upward revision to the core inflation forecast in June reflects growing risks, which may make it difficult for further dovishness ahead.

Mixed Evidence on Wages

Negotiated wages overshot expectations in Q1. While some of the more important voices in the ECB have downplayed the importance of this as one-offs and likely to be absorbed by cost margins, the more hawkish members are increasingly voicing their concern. For now, the ECB’s 2024 target for employee compensation seems reasonable (Chart 3).

As in the UK, the sector-level wage growth is important. Evidence suggests that wage growth has been concentrated most in services, but granular industry-level wage data is difficult to come by at the EZ level.

At the national level, there is some mixed data. Pay in the most important wage-intensive sectors (accommodation & catering) is rising at varying levels between France and Germany. In France, YoY wage growth in the sectors has slowed significantly recently, correlating well with inflation in those sectors. It is still running hot versus historic averages but is growing slower than most other services sectors. Meanwhile in Germany, wage growth is far more volatile, running at a far higher YoY rate, and sits at the top end of services wage growth (Chart 4).

Unit Profits

Unit profits are a key indicator for the ECB of cost pass-through to consumers. So far, the evidence from both top-down and bottom-up analysis (Charts 5 & 6, respectively) suggest that profit margins are shrinking sharply across Europe.

Appendix: Recent Policymaker Comments

Appendix: Surveys and Data Graphs

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Henry Occleston is a strategist who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)