29th Sep 2023

ECB's Lagarde says profits are two-thirds of inflation

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Economists and monetary authorities are increasingly coming around to the view that inflation for the past two years was primarily driven by corporate price gauging, not wages or high demand.

"Unit profits contributed around two-thirds to domestic inflation whereas, in the previous 20 years, the average contribution was one-third," said European Central Bank president Christine Lagarde on Tuesday (27 June).

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"We haven't seen a rise in aggregate demand in Europe [since 2019]," said Silvana Tenreyro, a member of the monetary policy committee of the Bank of England.

Speaking at the ECB Forum, a three-day event which takes place annually in the palace town of Sintra in Portugal, Lagarde set the stage for discussions about inflation, which has proven more "persistent" than expected despite demand not growing.

As one of the main events for top academics, economists and central bankers to gather and discuss monetary policy, markets will especially keep an eye on the headline debate between ECB's Christine Lagarde, US Federal Reserve chair Jerome Powell, Bank of England chief Andrew Bailey and Kazuo Ueda of the Bank of Japan —which will take place on Wednesday.

Core inflation in May was 5.3 percent, lower than a month before. But the ECB is mandated to bring inflation down to two percent.

Faced with "persistent" inflation, Lagarde said interest rates would be raised further in July.

Profit-price spiral

When the political economist Isabella Weber, an economy professor at the University of Massachusetts Amherst, published a study in February showing corporate profits are driving inflation, many mainstream economists did not believe it, with one calling the idea "truly stupid." But it has since found broad mainstream support.

When asked whether the 'profit-price spiral' is real, ECB chief economist Philip Lane said in the bank's own podcast programme released on Saturday that it "captures a lot that is going on."

On Monday, the International Monetary Fund also published a study showing "rising corporate profits were the largest contributor to Europe's inflation." This follows an earlier analysis by the OECD previously covered by EUobserver.

Describing the "intensity" of recent corporate profit hikes as "unusual", Lagarde on Tuesday said that prices have increased more than wages, resulting in a "large real wage decline."

This means that wage earners bear the burden of inflation. A graph shown during one of the presentations revealed that household savings accumulated during the pandemic have all but evaporated over the past year.

Lagarde warned on Tuesday that inflation is now entering a "second phase" where wage earners will try to compensate for lost ground. Until 2025 the ECB expects wages to increase by 14 percent in real terms.

This will increase the cost of labour per unit, compounded by low productivity growth, which can be explained by a general shift from manufacturing towards services where productivity gains are generally low.

Lagarde did not call for wage restraint, however. "We need to make sure firms rising labour costs are absorbed by firms," said Lagarde. This way, we can move towards "disinflation overall while real wages can recover some of their losses," she said.

No influence over profits

The central issue facing the ECB is that it does not have the tools to influence corporate pricing behaviour directly, nor can it influence labour negotiations.

"We cannot do much against inflation triggered by a supply shock," said Italian central banker Fabio Panetta, a member of the ECBs executive board, on Tuesday. "Monetary policy only influences [domestic] demand."

This simply means that increasing the cost of borrowing through interest rates— the central bank's main tool to deal with elevated prices— does not affect companies' willingness to raise prices. It only lowers the willingness to spend, which on the labour side, has a downward effect on wages.

EU: Wage-earners will 'bear brunt' of inflation in 2023

The European Commission raised its economic growth forecast but notes that inflation will continue to eat into household income while the contribution of corporate profits to price pressure is expected to remain high in 2023.


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