Attempting to mitigate the rate of inflation requires first-hand economic data. But that’s not all, because reality must at some point confirm the results of the forecasting models. “And we know that the predictions have been wrong in the recent past,” ECB executive committee member Isabel Schnabel said at an informal meeting of the Luxembourg-Frankfurt Financial Professionals Network.

On the evening of 22 September, some 40 representatives of the Luxembourg and Frankfurt financial centres met at  Spuerkeess’s 19 Liberté building for a dinner talk with Schnabel on “a subject that concerns us all, namely inflation”.

If the inflation rate in the euro zone, currently at 9.1%, is a cause for concern, so is the slowdown in the economy. This is not to mention that interest rate hikes are intended to cause a contraction in economic activity by the hand of central bankers, in addition to the natural shrinkage caused by the supply shock of raw materials and energy.

The complexity of anticipating economic reality stems from the fact that “there is no single indicator that shows a full range”, explained Schnabel. “We have to do the same as in the past, we have to be innovative and try to find other indicators.”

Perception on the ground

In this particular period, forecasting models are showing their limits, but there are indicators on the ground, such as the Purchasing Managers’ Index, which provide data from the real economy. As a result, the ECB takes them very seriously. But on this side, the signs of a slowdown in business activity are very clear. The eurozone manufacturing PMI fell to 49.60 in August, below the 50 threshold line that signals a risk of future contraction. While the services PMI was still holding at 51.20 in July, it fell to 49.80 in August.

The good news is that “there is an important supporting factor, the labour market”, stated Schnabel. “The labour market has proven to be very resilient…. Despite the economic downturn, unemployment rates are historically low.” While the eurozone unemployment rate stood at 6.6% in July, it had fallen by 0.1% compared to June and by up to 0.8% compared to its pre-pandemic level.

A low unemployment rate is a positive indicator, but “the question is also whether the labour force will increase,” stressed Schnabel. “There is a shortage of labour in many countries. This puts a strain on the production capacity of companies.”

The price-wage spiral

In such a context of labour scarcity, the message from the ECB executive board member is clear: “A number of companies may have an interest in keeping their employees, because if they don’t, then they will have difficulty getting them back later.” Schnabel highlighted the importance of government measures to support employment. According to the data she presented, labour shortages have already reached more than 35% in the service sector and almost 27% in the manufacturing sector in August.

While the unemployment rate serves as a bulwark against the risk of recession for the time being, wage levels are the key indicator to watch to avoid further runaway inflation. “Wage growth remains moderate in the eurozone,” she said, comparing the situation with the US, where wage growth is faster. Nevertheless, “they have to increase because of job shortages”. This means that “the risk of a price-wage spiral must be monitored very carefully”.

Too rapid increases in wages could lead to price increases, thus generating additional inflation. Although negotiated wage growth fell to 2.4% in the second quarter from 3% in the first quarter, recent wage settlements are generating significant volatility in annual wage growth rates. We will therefore have to wait for the third quarter data to identify whether any trend is confirmed. In the meantime, there will be uncertainty.

The window of opportunity for central bankers therefore remains narrow and the scope for action is narrowing, a veritable balancing act between likely further increases in inflation and the materialisation of the risk of recession. The cornerstone of this is employment indicators, which are the ECB’s main focus.

Originally published in French by and translated for Delano