Economic Insight: Euro area - Inflation target will be achieved if unemployment continues to fall

  • Recent surveys indicate that labor demand remains high and the number of job vacancies is rising. Therefore, we expect the positive trend to continue well into 2018. However, a distinct rise in employment will probably be accompanied by a much smaller decline in unemployment.

  • This recovery in the European labor market should, according to the Phillips curve, reinforce wage growth and make it easier for the European Central Bank to hit its inflation target of close to 2%.

  • Recently, the link between unemployment and wage growth has been questioned, as falling unemployment has not led to an appreciable acceleration in wage growth. Our findings do not confirm the view that the Phillips curve is defunct. Based on estimates for the period since 2001, we find that unemployment did have a significant negative influence on wage growth in euro area countries. The fact that the level of unemployment in the euro area has remained high can help to explain why wage growth is still sluggish (currently 1.6%). 

  • Assuming further falls in unemployment, our estimations predict euro area wage growth of 2.4% per employee by the end of 2019 and growth in unit labor costs of 1.5-2%. Such cost pressures would move the ECB’s inflation target within reach and hence point to a normalization of monetary policy over the medium term.