Europe’s inflation fix requires corporate pain

Bad service. Wanted: Euro zone CEOs to fight inflation. European Central Bank President Christine Lagarde is unlikely to take out an advert in a newspaper to recruit corporate chiefs but that wouldn’t be a bad message to convey. Unless companies’ margins fall, absorbing labour costs, it will be tough for the ECB to cut rates decisively.

The latest inflation numbers contain good news for Lagarde. Overall price growth in August slowed to 2.2% year-over-year, from 2.6% in July. That’s the lowest point in three years and very close to the ECB’s 2% target. In normal circumstances, that drop would vindicate the ECB’s decision to lower rates in June and strengthen the case for another cut in September. Unfortunately, the services sector has not got the memo. Annual price growth of haircuts, restaurant meals, flights and hotels and the like jumped from 4% in July to 4.2% in August – a 10-month high.

Services have been Lagarde’s main headache for months. They make up around 45% of the euro zone’s inflation basket but they have accounted for 70% of headline inflation in 2024, ECB executive board member Isabel Schnabel said on Friday. Admittedly, the latest rise may have been caused by one-off jumps in the prices of hotels and transport during the Paris Olympics.

But even before that, services inflation was stubbornly high. The problem is that services are more labour-intensive than goods. As a result, their prices more closely reflect the cost of employing people, which have been rising. Unit labour costs, which encompass both wages and productivity, increased at a heady annual rate of 5.3% in the first quarter. That may abate soon, largely because pay rises are getting smaller.

But unit labour costs will still rise by 4.7% this year, ECB staff estimates. To curb inflation, CEOs and shareholders will have to shoulder some pain in the form of lower margins. Unit profits – a measure of corporate profitability – rose by 6.2% last year. The ECB estimates that rate would have to plummet to 0.1% for headline inflation to be 2.5% this year.

That is already happening. In the first quarter, unit profits made a negligible contribution to inflation. The bad news for investors and CEOs is that they will have to keep shrinking, especially in the services sector, to give the ECB comfort to slash rates.

In that case, consumers will benefit from the double whammy of lower rates and more moderate prices. Shareholder in Europe’s transport and hospitality stocks, however, will need to brace for leaner returns.

Context News

Inflation in the euro zone fell to an annual rate of 2.2% in August, down from 2.6% in July, according to the first official estimate of this month’s price growth released on Aug. 30. The drop puts the bloc’s inflation within a whisker of the European Central Bank’s 2% inflation target. However, Frankfurt policymakers will be concerned by persistent price pressure in the services sector. Services inflation rose to 4.2% in August, from 4% in July, the data showed.