On the Eurozone’s Supposedly Stubborn Services Prices

Flash inflation (broadly rising prices across the economy) readings for Germany and France hit the wires Thursday, and commentators we follow echoed the narrative we have seen about US inflation over the past several months: Improvement is encouraging, but sticky service prices show high wages are still a problem. In our view, this take is telling about the gap between sentiment and the economic reality in the eurozone—a bullish feature for stocks.

If you simply saw the rhetorical commentary and hadn’t seen the numbers, you might think the inflation rates in question are still lofty. And yet, the headline German harmonised consumer price index (HCPI, a government-produced index tracking prices of commonly consumed goods and services) clocked in at 2.7% y/y (down from January’s 3.1%), with services inflation holding steady at 3.4%.^[i] France’s figures were similarly improved, with headline inflation slowing from 3.4% y/y to 3.1% and services prices from 3.2% to 3.1%.^[ii] Both are slower than US services prices and look high only in comparison to the 2010s’ perpetually below-average inflation … which commentators we follow argued was problematic back then.^[iii]

Anyway, none of this is our attempt to predict the European Central Bank’s (ECB) next move, but we don’t agree with commentators we follow who portray this as a policy conundrum. In our experience, people see services prices as sticky because they can’t apply the standard retail goods pricing model, which would presume consumer prices slow and perhaps even fall as suppliers’ costs go down. Yet we find people still cling to the notion consumer prices always and everywhere depend on input prices. And since wages can be an easy-to-see services cost input, we have seen many presume services prices rise in tandem with wages. So with wages rising in Germany and France, commentators we follow claim there is something of a vicious cycle at work.^[iv]

That is the theory. We think reality differs, showing across time and countries wages follow prices, not the other way around, as employers have to pay more to compete for workers as living costs rise. American Nobel laureate economist Milton Friedman made what we consider to be the definitive rhetorical case for this in the late 1960s, and data since have supported his argument.^[v] We think those who argue wages push services inflation overlook this, along with the fact businesses could easily cut other costs to support higher wages without raising prices anew. They could add automation to improve productivity. Or they could be taking advantage of lower energy costs.^[vi] Or or or! It is the sort of math and planning that we see reports of businesses doing all the time.

So where commentators we follow portray growing wages as call for gloom, we see bricks in the proverbial wall of worry bull markets are often said to climb. Far from being inflation fuel, in our view, higher wages restore some of the purchasing power people across the developed world lost in 2022, which we think should contribute to improving economic data.^[vii] Probably not a massive tailwind, but when it is so underappreciated, we find it doesn’t need to be to continue delivering a positive surprise.