The IMF has released yesterday an article written by Niels-Jakob Hansen, Frederik Toscani, Jing Zhou, which links the rise of corporate profits with the inflationary effects seen in Europe. The effect is not small at all, as companies hedged rising cost at the expense of consumer income.
Rising corporate profits have played a major role in driving up inflation in Europe over the past two years. Companies have increased prices more than the spiking costs of imported energy, accounting for almost half of the inflationary increase. However, now workers are demanding higher wages to compensate for lost purchasing power, and companies may have to accept smaller profit margins in order to keep inflation on track to reach the European Central Bank’s 2-percent target by 2025.
In October 2022, inflation in the euro area reached its peak at 10.6 percent due to surging import costs following Russia’s invasion of Ukraine. Companies passed on more than the direct increase in costs to consumers, exacerbating inflation. Although inflation has since decreased to 6.1 percent in May, core inflation, which is a more reliable measure of underlying price pressures, remains stubbornly high. This puts pressure on the European Central Bank to continue raising interest rates, despite the euro area slipping into recession earlier this year. Policymakers raised rates to a 22-year high of 3.5 percent in June.
An analysis reveals that higher inflation has mainly been driven by increased profits and import prices, with profits accounting for 45 percent of price rises since the start of 2022. Import costs accounted for about 40 percent of inflation, while labor costs accounted for 25 percent. Taxes had a slightly deflationary impact. This suggests that businesses in Europe have been shielded more than workers from the adverse cost shock. While profits have recovered to pre-pandemic levels, wages remain below trend.
However, as energy prices surge, it is expected that labor costs will increasingly contribute to inflation. Wage gains typically lag behind price increases due to infrequent wage negotiations. Workers, after experiencing a decline in real wages in 2022, are now seeking pay raises. The key question is how fast wages will rise and whether companies will absorb higher wage costs without further raising prices.
Assuming nominal wages rise at a pace of around 4.5 percent over the next two years, and labor productivity remains steady, businesses’ profit share would need to return to pre-pandemic levels for inflation to reach the ECB’s target by mid-2025. If wages increase more significantly, around 5.5 percent, to restore real wages to pre-pandemic levels by the end of 2024, the profit share would have to decrease further for inflation to return to target.
To anchor expectations and maintain subdued demand, it is important for macroeconomic policies to remain tight. This would encourage firms to accept a compression of profit margins, allowing for a measured recovery of real wages.
