How tit-for-tat inflation can make everyone poorer

30 March 2023

Oscar Arce, Elke Hahn and Gerrit Koester^[1]

Inflation in the euro area has been high recently, mainly because of a surge in energy prices.^[2] Since the euro area imports more than half of the energy it uses and energy has become much more expensive, households and firms have lost real income.^[3] This has been made worse by supply chain problems which have also driven up import prices.^[4] In such a situation, firms have an incentive to try to minimise their share of the burden by raising their prices in order to protect their profit margins.^[5] Producers in some sectors might even try to increase their margins over and above what would be justified by higher input costs to also fully recoup previous real income losses from the various shocks of the past three years. Another motivation could be the attempt to build buffers in an environment of high uncertainty.

Likewise, workers want to minimise their share of the burden by adjusting their wage claims to recoup the real wage losses resulting from higher prices. While price adjustments of firms can happen relatively quickly, wage setting is usually staggered in euro area countries and often requires a long negotiation process.

Risk of an upward price spiral

Both effects are pushing up prices in the euro area. And the mutually reinforcing feedback between higher profit margins, higher nominal wages and higher prices risks strong second-round effects. This can cause an upward price spiral. And, ultimately, it might push long-term inflation expectations away from the anchor of the ECB’s 2% target. This “tit-for-tat” dynamic, as it was described by ECB President Lagarde in a recent speech, must be avoided to keep inflation at bay.^[6]

So what does actually drive up inflation, profits or wages? The contribution of wages and profits to domestic price pressures in the euro area can be assessed based on the GDP deflator. This shows us the prices of the gross value added (including taxes less subsidies on products) produced in the euro area.^[7] The GDP deflator can be broken down into unit profits (gross operating surplus per unit of real GDP), unit labour costs (compensation of employees per unit of real GDP) and unit taxes (which reflect taxes on production net of subsidies per unit of real GDP).^[8]

Chart 1

GDP deflator income side

(annual percentage changes; p.p. contributions)

Domestic price pressures have increased strongly since the second half of 2021 (Chart 1). In the fourth quarter of 2022, year-on-year growth of the GDP deflator picked up further, to 5.8%. This highlights workers’ and firms’ strong reactions to energy and input cost pressures and shows that the intention to offset real income losses became a driver for higher inflation. The latest increases in the GDP deflator have been driven by both unit labour costs and unit profits. Unit profits increased by 9.4% in the fourth quarter of 2022, year-on-year, and contributed more than half the domestic price pressures in that quarter, while unit labour costs increased by 4.7% and contributed less than half.

Usually unit profits are influenced by the economic cycle and the terms of trade.^[9] Based on historic evidence one could have expected that the cyclical slowdown in economic activity and the still-worsening terms of trade should have dampened profits. But these factors appear to have been dominated by others recently and we are seeing rising profits.

Many companies are apparently able to expand their profit margins without facing significant losses of market shares. Why is that? The first reason is demand outpacing supply in many sectors: surging demand for certain goods and services after the pandemic met the widespread supply constraints of firms that are finding it difficult to get sufficient raw materials, intermediate goods, equipment and workers. High input prices (for example for energy) also made it easier for firms to increase their profit margins, because they make it harder to tell whether higher prices are caused by higher costs or higher margins. And since, as highlighted above, companies aim to recoup their real income losses whenever possible, the high inflation environment can provide a further opportunity to do so.

Chart 2

Sectoral wage and profit developments

(percentage changes over the indicated period)

A comparison of developments since the start of the pandemic (Chart 2) shows that in the euro area as a whole unit profits have increased faster than unit labour costs since the start of 2022, in some economic sectors already since the end of 2019. Zooming in on sectoral developments, we see that profits have grown much more than labour costs in:

• the agricultural sector, supported by rising food prices;
• energy and utilities (including electricity and gas), where some producers profited the most from higher energy prices;
• construction, where firms benefitted from the higher demand for housing after the pandemic;
• manufacturing, where input costs surged and restrained supply faced high demand;
• contact-intensive services sectors, where firms are still facing a strong and persistent rebound of demand in the face of limited supply since the reopening after the pandemic.

Chart 3

Contributions of unit profits and unit labour costs to domestic price pressures as reflected in the GDP deflator

(relative shares and deviations)

If we compare the relative contribution of unit profits and unit labour costs to domestic price pressures over a longer horizon (Chart 3) we see that, most recently, the effect of profits on domestic price pressures has been exceptional from a historical perspective. While, on average, from 1999 to 2022 unit profits contributed around one-third to the GDP deflator, over 2022 they contributed an average of two-thirds.

Domestic price pressures are a main driver of underlying inflation as measured, for instance, in terms of HICP inflation excluding energy and food. If the growth in the sum of profits and wages doesn’t slow, it will make the ECB’s goal of returning inflation to target in a timely manner harder. And that could require a stronger policy response. In their latest macroeconomic projections,^[10] ECB staff foresee that both unit labour costs and profit margins will grow more moderately over the next three years. There are a number of factors behind this. First, the projections implicitly assume that wage claims trying to catch up to inflation should ease over time, as euro area inflation gradually declines thanks to lower energy and other commodities costs. Second, the ECB’s restrictive monetary policy stance is also dampening demand. Third, unit profits are expected to grow more moderately as the mismatches in demand and supply are resolved and inflation eases.

In a less-benign scenario, where wage and price setters try to offset any real income losses, we would face the risk of successive wage and price adjustments ultimately leading to a wage-price spiral with lasting effects on inflation. The resulting aggregate real income loss would likely be deeper and more persistent. From a monetary policy perspective, it is therefore essential that such a risk scenario be avoided.

The ECB is closely monitoring developments in underlying inflationary pressures that stem from both profits and wages. These are important elements in our comprehensive analysis of underlying inflation developments^[11] and our data-based approach to policy rate decisions. And these monetary policy decisions will ensure rates that dampen demand, keep inflation expectations anchored and, over time, reduce inflation and ensure that it returns to the 2% medium-term target in a timely manner.

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.