Oliver Mangan: Widening profit margins helping drive underlying inflation

Demand has outpaced supply in many sectors following the pandemic. Pent-up demand was unleashed at a time of major disruptions to supply chains and capacity constraints in economies.

There was a welcome sharp fall in the headline rate of inflation in the eurozone for March as the sharp jump in energy prices following the Russian invasion of Ukraine early last year started to drop out of the annual calculations.  

The annual rate of inflation across the eurozone fell to 6.9% last month from 8.5% in February, and is now well below the peak level of 10.6% hit last October. 

Meanwhile, the Irish inflation rate fell from 8.1% to 7% in March, and US inflation is already well on its way down, with the headline consumer price rate there declining to 6% in February from a peak of 9.1% last summer.

Further big falls in headline inflation rates are in store in the coming months. 

However, this is where the good news story on inflation comes to an end.

When you exclude energy items, inflation remains both at high levels and is sticky. 

The monthly rise in the eurozone inflation rate, but excluding energy items, was 1.3% in March, with the annual rate continuing to accelerate to reach 7.9%. 

Core inflation remains sticky in the US and elsewhere too.

Energy prices

Wholesale energy prices have been in marked decline since last summer and are now below the levels that prevailed ahead of the Russian invasion of Ukraine. 

So why has a temporary, albeit very large, spike in energy prices generated a persistent inflation problem? 

Wage growth picked up in response to the surge in inflation, but wage increases are still lagging well behind the rise in consumer prices. 

And the rates of wage increases are already starting to moderate in economies like the US and UK.

Instead, it would appear that a widening of profit margins is the principal factor behind the sharp rise in underlying inflation. 

The US has seen a surge in corporate profit margins in the last two years to levels that are well above historical norms, according to official data. 

A recent excellent paper from the European Central Bank, "How tit-for-tat inflation can make everyone poorer", clearly demonstrates that soaring profit margins are mainly responsible for the marked pick-up in eurozone inflation over the past year.

The European Central Bank paper shows that profit margins rose at a much faster pace than unit labour costs during 2022, right across the whole economy. 

It was most pronounced in the agriculture sector, which has resulted in extremely high levels of food price inflation which is now running at 15.5%. 

However, it was also evident in manufacturing, construction, energy, utilities and personal services. 

As a result, while increasing profit margins contributed about one third to the broadest measure of inflation in the economy on average since 1999, they accounted for two-thirds in 2022.

Demand outpaces supply

How have firms been able to do this? 

The first reason, the European Central Bank concludes, is that demand has outpaced supply in many sectors following the pandemic.

Pent-up demand was unleashed at a time of major disruptions to supply chains and capacity constraints in economies. 

This allowed firms to expand their profit margins without fear of losing out on their market share. 

Secondly, rising inputs costs made it easier for firms to mask increasing their profit margins, and to pass both on to customers in higher prices.

The outcome will be that workers will demand higher wages if this behaviour persists.

The European Central Bank notes there is a risk that a wage-price spiral develops. 

Any such spiral can be expected to be met with a stronger policy response from monetary authorities that would see demand weaken significantly and force margin compression on firms. 

Thus, it would be better all-round if profit margins started to narrow soon of their own accord, helping core inflation to fall back.

Oliver Mangan is chief economist at AIB