Immigration can affect inflation, and therefore monetary policy, in two opposing ways, and the jury is still out on the overall impact of immigration on the euro area.
There are two main ways immigration can affect inflation: a) through labor supply and wages, and b) through increased demand for goods and services.
Clearly, immigration increases labour supply and can put downward pressure on wages. This effect on wages depends on the skill composition of immigrants and whether they really fill the skills required in sectors with high vacancies. At the same time, immigration increases the demand for goods and services as well as housing. In the long run, highly skilled immigrants tend to increase entrepreneurial activity, which ultimately leads to higher productivity and economic growth.
In theory, these two main channels affect inflation in two opposing directions: an increase in the supply of labor should dampen inflation, while an increase in demand for goods, services, and housing tends to increase inflationary pressures, at least initially.
In the euro area, the labour force – the combined employed and unemployed – has expanded rapidly since the pandemic, growing at a much faster pace than before the pandemic.
From the fourth quarter of 2019 to the same period in 2023, the labor force grew by 2.8%. This expansion was driven largely by foreign workers. In the euro area, about 70% of the labor force growth is due to an increase in foreign workers. However, since the labor force includes both employed and unemployed people, foreign workers may also be driving up the unemployment rate. The total number of employed people in the euro area has increased by 5.3 million since the fourth quarter of 2019, of which 3 million are foreign workers. Thus, here most of the increase in the number of employed people is due to foreign workers.
Yet for this to be relevant for inflation, labour shortages would need to be a bottleneck in the economy. While euro area inflation in 2021 and 2022 was driven primarily by supply shocks, services inflation is now the main driver of headline inflation above target. Services companies often cite high wage growth as the main driver of higher selling prices. Labour shortages are therefore a key driver of euro area inflation at the moment, and are of increasing importance, especially as companies have signalled that labour shortages are limiting production, vacancies have hit record highs and unemployment is now at an all-time low. Without immigration, these bottlenecks would be even more severe.
Beyond the euro area level, there are large differences across countries and sources of labour force expansion. In Germany, the number of nationals in the labour force has fallen by more than 500,000 over the past four years, mainly due to retirements, while the number of foreigners in the labour force has increased by more than 900,000. Without foreigners, Germany's labour force would have decreased rather than increased. Similar trends can be seen in Austria and Portugal. In Spain, both nationals and foreigners contributed significantly to the growth of the labour force, while in the Netherlands and Belgium the impact was rather small compared to the increase in nationals. Italy and Greece saw a decline in the number of foreigners in the labour force.
Looking at the job vacancy rate as an indicator of whether labour shortages are relevant, we see that labour shortages are a much more pressing issue in the Netherlands, Belgium, Austria and Germany than in, say, Italy or Spain. Across the euro area as a whole, foreigners have contributed to expanding the labour supply, which, according to Jerome Powell's logic, contributes to easing price pressures, or at least wage pressures. This is more pronounced in Germany and Austria than in the other major euro area economies, because they have larger labour shortages and the contribution of foreigners to expanding the labour supply is much larger than in other countries.
The impact of immigration on demand for goods, services, and housing is less straightforward.
In the words of former European Central Bank President Mario Draghi, “more people can buy more goods.” In simple terms, this is the effect of immigration on the economy and therefore inflation. Naturally, not all new immigrants are integrated into the workforce, so immigration may create demand that exceeds supply.
Indeed, the total net migration (including migration within the euro area) of euro area countries was just over 3.6 million in 2022, the latest year for which data is available. This is up from 1.1 million in 2021, and probably reflects Russia’s war in Ukraine to a large extent. From 2019 to 2022, net migration reached 5.8 million, with 2.6 million new non-national workers. For comparison, the chart below compares the annual growth rate of net migration from 2019 to 2022 with the growth rate of the non-national workers over the same period. Here we can see that most countries experience a much larger influx of immigrants than non-national workers, which is potentially an inflationary factor.
However, if an economy already has spare productive capacity, additional demand is unlikely to immediately cause inflation. Countries with small (or no) negative output gaps are less likely to experience the inflationary effects of immigration than countries that are overheating. At the moment, the euro area's output gap is very small, while countries such as Italy, Greece, Spain and Portugal are experiencing positive output gaps, indicating some degree of overheating. Germany's output gap, on the other hand, is negative. As a result, in Spain and Italy, the effects of increased net immigration through demand for goods and services are more likely to cause inflation compared to Germany.
The jury is still out on the overall macro effects of immigration.
Overall, we believe that the impact of immigration on inflation is not as simple as Jerome Powell has suggested. In fact, the question of how immigration affects inflation and monetary policy can only yield the typical economist answer: “It depends.” It depends on the state of the labor market, the capacity level of the economy, and the skills of the immigrants – that is, the absorptive capacity of the receiving economy.
Turning to the euro area, it is indisputable that the region's labour supply has increased over the past decade, mainly due to foreign workers, but it remains to be seen to what extent this has eased or actually increased price pressures.
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