Unpacking decreasing inflation: profit inflation vs. the heroic central bank
Ettore Gallo (@ettoregallo1 on X / Twitter)
University of Parma, Italy
Monetary Policy Institute Blog #122
“At some point, the process stabilized, both because of the fading away of the initial cost-push and of the fact that those constraints have been approached. Profit inflation is real, but temporary.”
Inflation is finally coming down, both in the US and in European countries.
In the wake of the COVID-19 pandemic, many high-income countries have witnessed inflation rates approaching or even exceeding double digits. In the case of the US economy, the increase in unit prices reached its zenith between the second and third quarters of 2022, following two years of continuous ascent. Subsequently, the inflation rate has gradually receded, tracing a pattern reminiscent of a bell curve, eventually returning to pre-shock levels (see figure below).
2023Q2
The fading away of inflation has been faster than expected for many analysts and policymakers. Since it has corresponded with an unprecedentedly fast increase in interest rates by the FED (and, in the EU, by the ECB), most commentators have attributed decreasing inflation to contractionary monetary policy. Vindicating the old monetarist mantra, central banks would have put an end to an era of ‘too much money chasing too few goods’ and, even better, they did that without harming production and employment. Mainstream outlets are also singing the praises of central banks for having restored price stability while ensuring a ‘soft landing’.
But not all that glitters is gold.
Inflation episodes always create winners and losers. In the post-COVID recovery, profits have contributed disproportionately more than wages to inflationary pressures. Despite some cyclical fluctuations mainly due to the recrudescence of the pandemic first, and of the energy crisis, then, the figure below shows that price changes have been associated with a significant increase in unit profits, whose evolution have greatly surpassed both overall price and wage changes. Conversely, labor costs have increased far less, with nominal wages starting to rise in 2021 but keeping below overall price increases, hence resulting in a reduction in real wages.
Over the last few months, the Monetary Policy Institute (here, here, here, here) and INET (here, here, here, here) blogs have hosted several contributions debating whether inflation was profit-driven, with opposing views.
A great deal of fuss revolves around the definitions of ‘profit inflation’ and the multifaceted notion of ‘conflict’. In the context of profit inflation, the actors in the debate hold divergent views, sometimes identifying it as a persistent process driven by greed, some others linking it with temporary price level increases resulting from cost-push shocks and mark-up/profit share targeting. Similarly, the term ‘conflict’ holds nuanced interpretations. On one hand, wages could be seen as the exclusive source of conflict, while on the other hand, the actions of profit earners defending and seeking to increase their margins could also be regarded as instances of social conflict.
In a paper co-authored with Louis-Philippe Rochon, we attempt to provide a synthesis of this debate, developing a micro/macro framework in which an initial cost-push shock has both a direct and indirect effect on prices and income distribution. These two channels lead to temporary inflation while permanently tilting the functional distribution of income in favor of profit earners.
In cost-plus pricing procedures, unit prices depend on two elements: (i) costs, e.g. labor, energy, raw materials, intermediate products and (ii) the mark-up.
There are many elements to believe that price surges both in the US and in Europe were caused by a cost-push effect, caused first by supply bottlenecks (after COVID-19 containment measures were eased) and then by energy price spikes following the Russian invasion of Ukraine (particularly significant in European countries). In a simple Kaleckian mark-up pricing equation, this would be associated with an increase in the price of energy, raw materials, and intermediate products.
Accordingly, ceteris paribus the mark-up, entrepreneurs would pass the higher price of energy, raw materials, and intermediate products to prices, with final products becoming more expensive. This is the first channel, with costs directly influencing prices. In this case, as wage costs become relatively less important in the firm’s cost structure, the share of wages in output will decrease and, conversely, the profit share will rise. Whether this can be called profit inflation is ultimately a matter of semantics. Nikiforos and Grothe contend that this is the case, while Marc Lavoie is of the idea that profit inflation occurs only when mark-ups are rising.
This brings us to our second point. In the unprecedented scenario of the post-COVID recovery, many firms — especially in those sectors labeled as ‘strategically significant’ by Weber and Wasner — did not limit themselves to defend their profit margins, but have actively tried to increase them by endogenously raising their mark-ups. This is undeniably what profit inflation is about.
As argued by Mark Setterfield, the pandemic shock relaxed the ‘fairness constraint’ implied in firms’ pricing procedure. This allowed firms to exploit the effects of rising concentration built up in the previous decades, with higher costs being the trigger of initial price increases, while providing a camouflage, then, for further increases caused by rising mark-ups (and thus profit margins). Firms cannot, however, raise mark-ups at will. On the contrary, mark-ups should be seen as strongly dependent on sectoral mark-ups, in turn affected by competition, concentration, and profitability constraints. At some point, the process stabilized, both because of the fading away of the initial cost-push and of the fact that those constraints have been approached. Profit inflation is real, but temporary.
The decreasing trend in inflation rates we are observing is vindicating this view. As many post-Keynesians believe that monetary tightening could only do so much when inflation is cost-based, the reduction of inflation rates could be attributed to the factors described above.
Does that mean that all’s well that ends well? Not quite. The rate of change of prices is going down, but their level is permanently higher. In the process, wage earners have lost purchasing power, while profit earners have been able to defend and sometimes increase their profit margins. In other terms, the post-COVID recovery has constituted yet another episode of perverse redistribution from wages to profits. Monetary policy can do little to reverse that, and most likely higher rates will contribute to making the process starker. Incomes policies — long forgotten in policymaking and policy debates — could be a valuable tool to foster real wage growth, allowing for an adequate increase in the wage share.
