Blanchard & Posen: Inflation tied to Corporations Trying to Maintain Profit Margins
I have posted this model of core inflation before. Core inflation on y-axis. Corporate-after-tax profit rate minus nominal rates on x-axis.
The model implies that inflation depends upon the difference between an aggregate corporate profit rate and nominal rates. The more nominal rates cut into corporate profit rates, the more corporations would choose to raise prices to maintain “net” profit rates… and thus create inflation.
Olivier Blanchard and Adam Posen wrote last December in 2015 an article titled, Japan’s Solution Is to Raise Wages by 10 Percent. As wages rise, corporate profit rates come down. So if you want to cut into corporate profit rates but cannot do it by raising nominal rates, then do it by raising wages. Either way, the data points move left on the x-axis making inflation increases more likely.
Olivier Blanchard and Adam Posen give the logic of the model when they say in their article…
“The point is not to redistribute income from business to labor. If anything, employers and other price setters should be encouraged to pass on the increased costs from wages to consumer prices and try to maintain their profit margins.”
The key to inflation is making corporations try to maintain their profit margins. But supply-side economics has lowered corporate taxes, lowered minimum wages, weakened unions and more in order to raise corporate profit margins. Is it any wonder that inflation will be low for years to come?
Totally amazing. I have always held that excess profits are inflationary, as are excessive compensation packages for executives…and a soaring stock market, since that is basically a bubble. I don’t believe in totally rational markets.
First, why would anyone want inflation? Oh, right, governments are up to their eyeballs in debt, so they want to devalue their currencies to pay their debt with less valuable money.
Why do we have bubbles, inflation? Warren you are so right there is always two sides to every story just as there is two sides to every ledger. It just depends what side of the profit margin you are on and who is controlling it. Wall St. or the Fed. I believe that there are many other factors in the world like competition for capital and the US millennial market demand for housing that will create higher prices and inflation. Then interest rates and inflation will eventually rise but job creation may have to come first. So it becomes the chicken or the egg syndrome of what comes first. I guess it really depends on who gets elected.
Carol, isn’t the chart saying that excessive profits coupled with low interest rates are ‘deflationary’? I find this chart interesting, if truly there’s relationship such as described in this chart, then Japan’s experiment could be telling.
On another note, as the economies adopt more automation and the contribution of wages (or lack thereof) goes down in corporate profits, creating inflation will become even more difficult.
Honestly, Pankaj, the only relationship this chart shows is (0.56F+0.44T) follows the inflation rate, and when inflation is high profits are unpredictable.
Warren,
You have to think of the dynamics behind the model. Let’s say profit rates are -1% and nominal rates are zero and inflation is 0%…. you would see inflation rise. Nominal rates could stay at zero and allow inflation to rise. Then think about wages rising anticipating more inflation. You would see inflation rise even more… all the time nominal rates staying at zero.
Currently unit labor cost are rising faster than the deflator for nonfarm business — 2.6% for cost and 1.1% for the deflator. Moreover, labors share of the pie is rising. Both of these conditions are late cycle events that tend to precede recessions. There has not been a recession since WW II that was not preceded by labors share of output rising. Of course, labors share rising is typically accompanied by the fed tightening. So what is the underlying causal relationship is open to debate.
Good point Spencer… For me the Profit cycle is what is key for a recession. Both nominal rates and labor share cut into profits. As well, when profits start downward, more firms tend to get caught in the downdraft, just as firms tend to get caught in the updraft when profits are rising.
Monetary conditions are tightening even as the Fed funds rate just sits there.
Again… your make great points to the discussion.
Didn’t Magdoff and Sweezy say this 40 years ago?
blavag,
Do you have a link for this? Where did Magdoff and Sweezy present this model? I cannot find anything.
“Nominal rates could stay at zero and allow inflation to rise.”
But they would not. While theoretically possible, it does not happen in reality.
Extended zero bound conditions did not exist in reality. Until they did. And do.
Why wouldn’t a combination of zero nominal rates and higher real wages push prices higher? (More money chasing same goods)
yes… That is the other way to move the data points to the left. You can lower after tax profit rates with higher real wages. But the key is to increase labor share. Just higher real wages may not raise labor share. It is possible to raise real wages and have labor share fall. Corporate profit rates are dependent on labor share.
“It is possible to raise real wages and have labor share fall.”
Ed I get that on a firm by firm basis or even sector by sector, but it is harder to see how that would work across the entire covered worker population. Someone has to do the work. Now of course people argue that the result would just be to automate the jobs away. But if it was that easy to automate most employers would have already done it. It seems unlikely that so many labor tasks across all sectors would suddenly tip towards cost effective automation by single digit percentage increases in wages. And those who push it always seem to be the self-interested posing as protectors of jobs. That is seldom is heard the straightforward argument “Well sure I could raise wages across the board. But it would pay hell with the executive profit sharing plan.” The truth is that employers are always seeking to cut costs, and in most enterprises the biggest cost sector is labor. Any actual concerns by management of large firms for “saving jobs” tend to me moot when the cost cutting rubber hits the road.
For example it is hard to find historical evidence that the movements for the Five Day Week and the Eight Hour Day actually reduced labor share individually, by sector, or overall. Or in the long run actually eliminated incentives for capital to be invested because of falling profit share.
Why doesn’t it happen in reality? It is like a cat and mouse. The cat is nominal rates. The mouse is inflation. If the mouse moves, the cat wants to react. But if the cat is not allowed to react, the mice can multiply. Mice population explosions are not uncommon.
Edward Lambert:
On Magdoff and Sweezy: Stagnation and Financial Explosion.
Note: this is out of the left tradition and not a formal model but the inflation/corporate profit tie is there.
Cheers