Profit taking a bigger driver of inflation than wage growth, ECB finds

The headquarters of the European Central Bank. Photo: Andreas Rentz/Getty Images

Donal O'Donovan

Booming profits are a bigger driver of inflation than pay hikes, researchers at the European Central Bank have confirmed.

The initial surge in inflation after the pandemic was caused by stress on supply chains and accelerated by energy price hikes after Russia invaded Ukraine.

As prices spiked last year, central bankers and policy makers were at pains to stress the need for wage restraint even as households came under pressure to avoid inflationary pressures becoming embedded and self-reinforcing.

However, a new paper published by the ECB 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 sectors the trend for profit growth outpacing pay increases goes all the way back to 2019.

The paper – ‘How tit-for-tat inflation can make everyone poorer’ – is published on the ECB website.

Profits have grown much more than labour costs, including in sectors of the economy people are least able to cut back spending.

That includes agricultural, where profit growth was supported by rising food prices. Inflation figures in Ireland for March show the rising cost of food accelerated this month even as inflationary pressure elsewhere eased.

Profits have grown much more than labour costs, including in sectors of the economy people are least able to cut back spending

Profit growth has also outpaced wages in energy and utilities, where some producers profited the most from higher energy prices, with similar trends in construction, manufacturing and the services sector where high post-pandemic demand met limited availability.

Across all sectors of the economy, unit profits increased by 9.4pc 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 4.7pc.

ECB researchers point to the hit to households as a result of inflationary pressure and the knock-on impact in pay talks between firms and workers with both sides looking to be insulated from the effects.

“If both sides try to unilaterally offset any real income losses, this could trigger successive wage and price increases, and create risks of an upward spiral that could make everyone poorer.”

The report says inflation in the euro area has been high recently, mainly because of a surge in energy prices.

When that happens, firms have an incentive to try to minimise their share of the burden by raising their prices in order to protect their profit margins and 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, they say.

“Another motivation could be the attempt to build buffers in an environment of high uncertainty.”

While the same is true for workers pressing for higher pay, that process tends to be slow while companies can put up prices quickly.

“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.”

The ECB thinks this “tit-for-tat” dynamic must be avoided to keep inflation at bay.