Why a more competitive economy matters for monetary policy

11 February 2025

By Marinela-Daniela Filip, Daphne Momferatou and Susana Parraga-Rodriguez

While companies in the euro area are getting more productive, they are doing so at a much slower pace than their competitors. Weak productivity growth is putting monetary policy in a difficult situation. When the economy struggles to grow and loses competitiveness this can increase inflationary pressures and reduce the space for monetary policy to manoeuvre. In this post we take a closer look how the loss of competitiveness affects monetary policy, where the issue has come from, and what can be done to reverse the trend.

How exactly does monetary policy interact with productivity?

In general, productivity growth – i.e. how many goods and services can be produced per hour worked – is a key determinant of the overall potential of an economy to grow. That, in turn, affects its natural rate of interest, which is an important factor for effective monetary policy. This is because a central bank raising its policy rate above the natural rate can cool down the economy. Lowering the policy rate below the natural rate can stimulate the economy. At the natural rate of interest, savings and investment are balanced and the economy can grow at its full potential without overheating and pushing inflation up or down too much. At this rate the economy can operate with price stability and full employment – an ideal state that sometimes is referred to as a “goldilocks economy”.

Higher productivity leads to higher potential output, which eventually leads to a higher natural interest rate. This gives a central bank greater scope to stimulate the economy in difficult times via lower rates while still keeping prices stable. It also makes the transmission of monetary policy to the real economy more effective, i.e. policy interest rates translate more directly into how restrictive or loose the financing conditions for people and businesses are.

However, when resources are not allocated efficiently and productivity is low, firms struggle to increase output. This low economic growth makes firms more sensitive to interest rate changes. Then, even small rate hikes by central banks to ensure price stability can further dampen growth, leading to a vicious circle. This is because low growth makes businesses more cautious about investment. Business sentiment may further deteriorate when high uncertainty and geopolitical tensions make energy and other raw materials more expensive. In such a situation, the room for monetary policy to manoeuvre shrinks.

And what about price stability in particular?

When input costs are growing fast, strong productivity growth can help the central bank to contain inflation. How? A sudden increase in input costs such as wages and energy can lead to cost-push inflation if not accompanied by corresponding productivity gains. And when higher prices lead to higher wage demands, this can create a wage-price spiral.^[1] That is why the ECB looks at unit labour costs (ULC) when it assesses wage and price developments. ULC are essentially the labour compensation needed to produce one unit of output and are a widely used indicator of competitiveness. Overall, lower ULC are associated with greater competitiveness. ULC developments can be decomposed into the contributions of compensation per employee and productivity. Robust productivity growth can go hand-in-hand with higher wages without compromising competitiveness. Chart 1 shows how the interplay of labour compensation and productivity significantly affects ULC. But production costs can of course also increase due to other factors, such as energy. Likewise, firms may push prices when seeking to increase their profits.

During the post-pandemic recovery, for example, high commodity prices and supply bottlenecks led to strong price increases in the euro area, initially alongside higher profits, requiring the ECB to increase interest rates.^[2] Over time, the price increases fed into higher wage demands so that workers could make up for their lost purchasing power. This led to strong ULC increases and weak productivity growth, but they were buffered by higher profits and a wage-price spiral was avoided.

Chart 1

Euro area ULC and components

When assessing euro area ULC developments, it is important to also look at what is happening in individual member countries. Differences in competitiveness are normal in a currency union when they reflect temporary adjustments to shocks or catching-up processes. But longer-term divergences can result in the euro area’s single monetary policy becoming less than optimal for individual countries.^[3] Countries with their own national currency have the option to regain competitiveness by lowering policy interest rates and devaluing their currency, but this option is no longer available in a currency union. The ECB sets its monetary policy by looking at the euro area as a whole and thus cannot address the specific needs of each country. That’s why it’s important to close competitiveness and inflation differentials between euro area countries. It doesn’t just strengthen the European economies; it also helps the ECB to implement its monetary policy more effectively.

Why is euro area productivity falling behind anyway?

Productivity in the euro area has been slowing consistently over the past three decades, falling behind that of the United States (Chart 2). This is due in part to inefficient work and ineffective technologies and the slow increase in machinery and equipment used per worker. Lacklustre productivity compared to other economies can also be traced to the weaker performance of European “frontier firms”. These are the most technologically advanced and productive companies within a particular industry, especially in the information and communication technology sectors. This relative underperformance is closely linked to lower firm dynamism (generally the rate at which firms enter, grow and exit the market), less investment and breakthrough innovation, and slower adoption of digital technologies.^[4]

Chart 2

Labour productivity gap between the euro area and the United States

(USD 2010, purchasing power parity per hours worked)

So, what can we do?

Low productivity growth in the euro area and the loss of competitiveness is amplified by additional challenges already on the horizon. The recent energy crisis demonstrated why Europe needs to be competitive, resilient and less dependent on other regions. Mario Draghi's report on the future of European competitiveness and Enrico Letta’s report on empowering the Single Market rightly stress the urgent need for policies to boost competitiveness and resilience. Coordinated and combined efforts are needed to develop and swiftly adopt concrete policy proposals such as the ones included in the recently published Competitiveness Compass for the EU. As detailed above, a more competitive economy also matters for the ECB, as it can support monetary policy in keeping prices stable, stabilising the economy, and thereby increasing the living standards of all euro area citizens.

The views expressed in each blog entry are those of the author(s) and do not necessarily represent the views of the European Central Bank and the Eurosystem.

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