Companies are profiting from inflation, forcing the ECB to face a harsh truth

Policymakers from the European Central Bank confronted some harrowing realities this week while huddling in a retreat in a remote Arctic village: businesses are benefitting from rising inflation while workers and consumers bear the cost.

The dominant macroeconomic narrative over the last nine months has been that the 20 nations that make up the euro zone’s businesses are facing higher costs as a result of recent steep rises in the cost of everything from energy to food to computer chips.

In an effort to reduce demand, the European Central Bank (ECB) responded by hiking interest rates to levels not seen in forty years. The ECB said that this was necessary because there was a danger that increased consumer prices would lead to wage increases and an inflationary spiral.

A significantly different image, however, emerged during the retreat in the Finnish hamlet of Inari designed to provide the bank’s Governing Council with an opportunity to dive into topics barely touched upon at regular meetings, according to three people who attended the meeting.

According to data shown to the 26 officials in more than two dozen presentations, firm profit margins have increased rather than shrunk as might be anticipated when input costs climb so steeply, the sources told Reuters.

For this report, an ECB representative objected to being interviewed.

“It’s clear that profit expansion has played a larger role in the European inflation story in the last six months or so,” said Paul Donovan, chief economist at UBS Global Wealth Management. “The ECB has failed to justify what it’s doing in the context of a more profit-focused inflation story.”

The general public is likely to be incensed by the notion that businesses have been raising prices above their expenses at the expense of consumers and wage workers.

Yet, it also affects central bankers.

Higher corporate margin-driven inflation is a far different beast to control than a wage-price runaway since it finally self-corrects when businesses hold off on price increases to preserve the market position.

According to economists surveyed by Reuters, a fresh inflation narrative centred on margins might provide the more dovish members of the Governing Council with more weapons to argue against additional rate increases after their opposition proved mainly ineffective over the last year.

The official story of inflation in the eurozone has been gradually beginning to change.

ECB and Germany’s Ifo institute polls show that businesses expect lesser price increases as the outlook for costs and demand grows less certain.

While France and Spain are discussing similar measures, certain European nations, like Greece, have proposed legislation to reduce inflation in the price of necessities.

“The economics of profitability suggest we might see more of a profit squeeze coming up,” ECB chief economist Philip Lane told Reuters. “European firms know that if they raise prices too much, they will suffer a loss in market share.”

The increase of profit margins began early in the United States and has already begun to reverse, albeit slowly and unevenly.

Yet, unlike the US, the eurozone lacks public corporate margin statistics. Instead, the inflation picture is shown using national accounts and profit reports from publicly traded corporations as proxies.

According to Refinitiv statistics, consumer goods businesses in the Eurozone increased operating margins to an average of 10.7% last year, up from 9.3% in 2018, before the worldwide pandemic and the crisis in Ukraine.

The 106 businesses surveyed varied from luxury goods company Hermes to Scandinavian retailer Stockmann to French vacation operator Pierre et Vacances.

The majority of domestic pricing pressures in the eurozone since 2021 have been driven by profits rather than labour costs and taxes, according to ECB calculations based on Eurostat data.

According to ECB estimations, the quality of living for the ordinary employee in the eurozone would decline by 5% from 2021 to 2020 since salaries have been increasing much more slowly than inflation.

It is essentially the reverse of the wage-led inflation that characterised the 1970s, which economists believe has been the most frequently referenced period of comparison in the public discussion on the proper answers for central bank policy.

For instance, during the most recent news conference of ECB President Christine Lagarde, salaries were referenced 14 times while margins were not addressed at all. Her deputy, Luis de Guindos, also warned that the ECB needed to be careful because labour unions would seek exorbitant wage raises.

Similar data sets were examined by the ECB officials assembled in Finland, according to the sources, who found that earnings had surpassed salaries due to both the spending of savings amassed during lockdowns and the ability of businesses to determine their own pricing.

The situation for ECB officials who have been advocating for a revision of the inflation story may be shifting now that those savings are being drained and competitiveness is returning.

The governor of the Portuguese central bank, Mario Centeno, was one among the first to raise concerns about the possibility of a sharp increase in profit margins in January and suggested that it be taken up on the European policy agenda.

Fabio Panetta, a member of the ECB board, later claimed that employees had bore the brunt of the price hike overall, despite the fact that corporation markups had remained unchanged or even grown in some industries.

The ECB’s forward-looking pay tracker predicts that for contracts signed in the final quarter of 2022, wages would increase by about 5% in 2023. But economists claimed it won’t make up for the sharp decline in real wages over the previous year.

According to data from Eurostat, during the previous inflation crisis in the 1970s, little over 20% of economic production went to corporations and over 70% went to workers. Nowadays, 56% of the economy is made up of labour, with 33% going to profits.

At their retreat in Finland, the ECB policymakers discussed these disagreements, however the sources there claimed that their early findings had a number of qualifiers.

A protracted time of high inflation may enhance compensation demands in a way that models created during periods of stable pricing fail to forecast, according to some, who noted that vacation plans during the pandemic may reinforce earnings.