Supply Chain Backlog, Profit Taking, or Labor Driving Inflation?

Corporate profits have contributed disproportionately to inflation. How should policymakers respond? Economic Policy Institute, Josh Bivens

The inflation spike of 2021 and 2022 has presented real policy challenges. In order to better understand this policy debate, it is imperative to look at prices and how they are being affected.

The price of just about everything in the U.S. economy can be broken down into the three main components of cost. These include labor costs, nonlabor inputs, and the “mark-up” of profits over the first two components. Good data on the separate cost components exists for the nonfinancial corporate (NFC) sector for companies producing goods and services. This segment of the economy makes up roughly 75% of the entire private sector. I would detail manufacturing costs further; Direct Labor, Overhead, and Material with Direct Labor being the smallest component of Cost. Then there is markup.

Since the trough of the COVID-19 recession in the second quarter of 2020, overall prices in the NFC sector have risen at an annualized rate of 6.1%. This is far greater than the 1.8% price growth experienced pre-pandemic business cycle of 2007–2019. Over half of this increase (53.9%) can be attributed to fatter profit margins, with labor costs contributing less than 8% of this increase.

This is not normal. From 1979 to 2019, profits only contributed about 11% to price growth and labor costs over 60%, as shown in Figure A below. Nonlabor inputs—a decent indicator for supply-chain snarls—are also driving up prices more than usual in the current economic recovery.

What does the abnormally high contribution of profits to price growth mean for how policymakers should respond to the recent outbreak of inflation?

• It is unlikely the extent of corporate greed or even the power of corporations generally has increased during the past two years. Instead, the already-excessive power of corporations has been channeled into raising prices rather than the more traditional form it has taken in recent decades of suppressing wages. That said, one effective way to prevent corporate power from being channeled into higher prices in the coming year would be a temporary excess profits tax.
• The historically high profit margins in the economic recovery from the pandemic sit uneasily with explanations of recent inflation based purely on macroeconomic overheating. Evidence from the past 40 years strongly suggest profit margins should shrink and the share of corporate sector income going to labor compensation (or the labor share of income) should rise as unemployment falls and the economy heats up. The fact the exact opposite pattern has happened so far in the recovery should cast much doubt on inflation expectations rooted simply in claims of macro-economic overheating.

Do fatter profit margins imply more corporate power—or just power channeled differently?

The rise in profit margins accounting for a disproportionate share of price growth in the current recovery has led to speculation of increasing corporate power as the key driver of recent inflation. Corporate power is clearly playing a role. The increase in corporate power likely has not happened recently enough to make it a root cause of the inflation of 2021–2022. In fact, the rapid rise in profit margins and the decline in labor shares of income during the first six quarters of the current recovery is not that different from the rise in the first few years following the Great Recession and financial crisis of 2008. 

Figure B below shows the timing of the rise starting from the trough of the recession (zero on the horizontal axis). The fall of labor’s share of income was actually more pronounced during the early recovery from the Great Recession than it has been so far in the recovery from the COVID-19 recession.

In the Great Recession recovery, increased corporate power did not manifest in faster price growth making room for fatter profit margins. Price growth was actually quite subdued over the first few years of the recovery. Instead, corporate power manifested itself in extreme wage suppression (aided by high and persistent levels of unemployment). Unit labor costs declined over a three-year stretch from the recession’s trough in the second quarter of 2009 to the middle of 2012. The general pattern of the labor share of income falling during the early phase of recoveries characterized most of the post–World War II recoveries, though it has become more extreme in recent business cycles (see Figures G and H in this report).

Given that the rise in profit margins was similar in the 2008 recovery and the current one, it’s hard to say some recent rise in corporate power is the key driver of current inflation. Rather, a chronic excess of corporate power has built up over a long period of time. It manifested in the current recovery as an inflationary surge in prices rather than successful wage suppression. What was different this time that channeled this power into higher prices rather than slower wage growth? The short answer is the pandemic.

One reason to think the pandemic is the root cause of the recent inflationary surge is empirical. The inflationary shock has occurred in essentially all rich nations of the world. It is hard to find any country-specific policy mapping onto inflation.

Another reason is to look where this inflation started: the rapid run-up of prices in the goods sector (particularly durable goods). The pandemic directly shifted demand out of services and into goods  (people quit their gym memberships and bought Pelotons, for example) just as it also caused a collapse of supply chains in durable goods (rolling port shutdowns around the world).

In previous recoveries, domestic demand growth was slow and unemployment was high in the early phases of recovery. This led firms to become desperate for more customers. It also gave them the upper hand in negotiating with potential employees leading to subdued price growth and wage suppression.

This time around, the pandemic drove demand through the roof in durable sectors and employment rebounded rapidly. But the bottleneck in meeting this demand on the supply side was largely not labor. Instead, it was shipping capacity and other nonlabor shortages. Firms having inventory on hand as the pandemic-driven demand surge hit had enormous pricing power vis-à-vis their customers.

A temporary excess profits tax could have provided some countervailing weight to the pricing power firms currently have vis-à-vis their customers. Supporting such a tax does not mean a sudden rise in corporate power is the root cause of current inflation. However, corporate pricing decisions in a pandemic-distorted environment can be a propagator of inflation. The recognition of the price spikes in many sectors over the past year are not useful market signals about where the economy’s resources should be redirected. Instead, they are just an extreme but short-lived mismatch between sectoral demands and supplies that will naturally unwind as the global economy normalizes after the pandemic.

High profit margins are generally not a signal of generalized macroeconomic ‘overheating’

Calls are getting louder for the Federal Reserve to adopt a much more contractionary stance of monetary policy by raising interest rates sharply. The rationale for this is simply, today’s high inflation must be driven by an imbalance of aggregate demand (planned spending by businesses, governments, and households) and aggregate supply.

But over the entire post–World War II period, accelerating economic recoveries and falling unemployment that might indicate that the economy was running “hotter” have been associated with rising real wages  and a rising labor share of income. The dynamic generally has been characterized by falling unemployment rates and increased bargaining power for workers. This in turn led to real wage growth threatening to outpace economy-wide productivity growth. If this dynamic was allowed to get out of hand, the result could potentially be a wage-price spiral. Firms could have to raise prices simply to meet workers’ wage demands and workers in turn demanding pay increases to insulate them from rising prices. To be clear, these instances of spiraling inflation driven by macroeconomic overheating have been far rarer than commonly characterized. A pattern of lower unemployment leading to faster wage growth and filtering through to some slight upward pressure on inflation is clear and consistent in economic data.

Currently, the labor share of income and real wages are falling sharply in the recovery even as unemployment falls. It seems strange to see a pattern in the data that is the complete opposite of how overheating-driven inflation has historically worked and not ask if it might be something different this time causing inflation (i.e., the pandemic).

Many of those most who are dismissive of claims of increasing corporate power has driving recent inflation adopt the view of a generalized macroeconomic overheating being the culprit. But in dismissing the increased corporate power explanation for recent inflation, they also seem to be discarding any useful information of recent sky-high profit margins providing the validity of their alternative view. Profit margins may not be telling us the recent increases in corporate power are the root cause of inflation. But they are telling us a simple macroeconomic imbalance of supply and demand is not driving inflation either. Unless the relationship between a “hot” economy and profit margins and real wages is just coincidentally behaving entirely differently in the current recovery than it has in the past.

It is true that in very recent quarters—between the second and fourth quarters of 2021, for example—profit margins have ticked down slightly (but are still extraordinarily high in historical terms) and labor cost growth has been running well above historical averages. But even in this much more recent period of the COVID-19 recovery, labor costs are contributing just 50% to price growth—well below their historic average. (AB: This I have an issue with its determination. It is a generalization)

The data signature of supply-chain snarls, nonlabor inputs have been contributing well above their historical average in this more recent period.

The overheating view often emphasizes the atypically fast nominal wage growth of the past year as justification of their arguments. However fast this nominal wage growth is, when compared to the recent past, it lags far behind overall inflation. The correct signals are, labor costs are still dampening, not amplifying, inflationary pressures.

In short, the rise in inflation has not been driven by anything that looks like an overheating labor market. Instead, it has been driven by higher corporate profit margins and supply-chain bottlenecks. Policy efforts meant to cool off labor markets such as rapid and sharp interest rate increases are likely not necessary to restrain inflationary pressures in the medium term.

Other tools that would be less damaging to typical families such as child care investments to boost expected growth in labor supply or a temporary excess profits tax could be effective in tamping down inflation over the next year and should be a bigger part of the policy mix.