Euro area: Inflation, wages and the ECB. How will it all end?

Euro area i nflation continues to trend low er and has been now below 3% for four months running. The ECB, however, remains reluctant to declare victory and demand s more evidence that the battle has been won , before starting to ease its policy stance. That reluctance is understandable. For one , the decline in inflation is not evenly distributed across the different price categories and services inflation remains sticky. Most importantly , wage growth looks too strong to allow a further decline of core inflation to the ECB’s 2% target. That said, when looking at the role of wages in determining core inflation in a more systematic way we find that the current rate of wage growth does not necessar ily prevent a decline of core inflation to the ECB’s target rate of 2%. While this may sound counterintuitive , it is important to keep in mind that average core inflation in the euro area up to the pandemic has been 1.4%. Relatively strong wage growth may consequently be needed to keep core inflation at the ECB’s target. Th at said, o ther factors – such as globalisation – have also contributed in the past to the low inflation environment. As world trade fragments, the past disinflationary impact may turn inflationary. “ Greenflation “ will also add some inflationary pressure . Given all this, it is understandable that the ECB will want to see some wage moderation before it is willing to start cutting its policy rates, though a decline back to the historical average is not needed. We expect this moderation to be sufficiently clear by the middle of the second quarter, allowing the ECB to start cutting rates by June.