ECB Study Explains Why Firms Cut Jobs Faster During Interest Rate Hikes

A new study by researchers from the European Central Bank (ECB), the National Bank of Belgium and the Banque de France sheds light on one of the biggest economic puzzles of recent years: why employment in Europe remained strong despite slow economic growth and repeated shocks.

After the pandemic, many economists expected unemployment to rise as businesses faced weaker demand, high inflation and rising costs. Instead, companies largely held on to their workers. The study says this was due to "labour hoarding" – a practice where firms keep employees even when business activity slows because they expect conditions to improve or fear they may struggle to hire workers again in the future.

How Monetary Policy Shapes Hiring Decisions

The researchers analysed data from more than one million firms across Germany, France, Italy and Spain between 1999 and 2020, along with detailed quarterly data from Belgium up to 2023.

Their findings show that monetary policy plays an important role in determining whether firms retain workers during difficult times. When interest rates are low and financing conditions are favourable, businesses are more likely to keep employees despite falling sales or output. Lower borrowing costs make it easier for firms to absorb temporary losses and continue paying wages.

When interest rates rise, however, companies face greater financial pressure. As borrowing becomes more expensive, firms are less willing or less able to keep excess staff, leading to stronger employment cuts.

Rate Hikes Have a Stronger Impact Than Rate Cuts

One of the most important findings of the study is that monetary policy does not affect employment in a balanced way.

The researchers found that restrictive monetary policy has a much stronger effect on labour markets than accommodative policy. In simple terms, interest rate hikes encourage firms to cut jobs much more strongly than interest rate cuts encourage them to keep workers.

Using both annual and quarterly data, the study found that the impact of monetary tightening on labour hoarding is roughly two to three times greater than the impact of monetary easing. This suggests that central bank rate increases can have a significant effect on employment, particularly during periods of economic weakness.

Small Firms Feel the Pressure Most

The study also reveals that not all businesses react in the same way.

Smaller firms are much more sensitive to changes in monetary policy than larger companies. Because they often rely more heavily on bank loans and external financing, rising interest rates affect their operations more directly.

The researchers also found differences based on workforce skills. Firms employing a larger share of lower-skilled workers tend to react more strongly to changing financial conditions. Companies with highly educated workers are generally more willing to retain staff because replacing specialised employees is costly and difficult.

Financial Strength Matters

A firm's financial health plays a major role in determining whether it can hold on to workers during downturns.

Businesses with high debt levels are more likely to reduce employment when conditions worsen. In contrast, firms with stronger profits and healthier balance sheets are better able to absorb temporary shocks and maintain their workforce.

The findings suggest that monetary policy influences labour markets not only by affecting economic demand but also by shaping firms' access to finance. Easier financial conditions help companies keep workers during difficult periods, while tighter conditions increase pressure to cut jobs.

As Europe continues to navigate an uncertain economic environment, the study highlights an important lesson for policymakers: interest rate decisions do not just affect inflation and borrowing costs. They also influence how many workers businesses are willing and able to keep on their payrolls when the economy slows.