European Central Bank working paper attributes euro area labour market resilience to real wage erosion and weaker employment response to monetary tightening

The European Central Bank published Working Paper No 3180 examining why euro area employment stayed unusually strong during the early-2020s inflation surge despite stagnating output. Using a long-run macro dataset and a structural VAR framework, the paper concludes that the decline in real wages was central to sustaining labour demand and helping to explain the decoupling between output and employment, while monetary policy shocks appear to have affected output more forcefully than employment. The analysis combines quarterly euro area data from 1970 to 2025 with a Bayesian structural VAR that separates aggregate demand and supply shocks, factor-substitution shocks, labour market shocks and monetary policy shocks, with the latter identified using an event-study monetary policy surprise instrument. Compared with the 1970s and early 1980s, when wage indexation and bargaining power contributed to rising real wages and larger unemployment responses to adverse supply shocks, the recent episode is characterised by real wage erosion and limited on-impact wage indexation, which the paper links to substitution toward labour when energy prices and borrowing costs rose. It also documents asymmetric transmission of monetary policy, noting that the policy-rate tightening between July 2022 and September 2023 coincided with output reacting sooner than employment, alongside pro-cyclical movements in labour productivity driven in part by the employment-output divergence.