Inflation now seems firmly on the retreat across most developed economies. While concerns remain regarding the speed with which inflation is expected to fall back to target and the UK in particular seems to grapple with stubbornly high core inflation, the trend is encouraging. Still, if you were to ask two economists for the reasons behind the 2021/22 inflationary spike, you’d probably get three different opinions, to paraphrase a famous saying.
In recent years, the New Keynesian models have been favoured by policy makers and central bankers, which explain inflation as the result of an excess of aggregate demand in relation to aggregate supply. Then there are the monetarists, which state that inflation is due to excessive growth in the money supply – in other words, inflation is too much money chasing too few goods. However, a third explanation has gained in popularity, that attributes inflation to firms’ price setting behaviour at times of industry-wide cost shocks. This is known as sellers’ inflation, or more popularly dubbed ‘greedflation’.
It is worth briefly explaining the conceptual framework of the theory. It departs from a period of stable economic relations where firms in a competitive market are not able to raise prices without losing market share to competitors. This equilibrium can be upset through a cost shock or supply bottlenecks in systemically important upstream sectors, say for example a shortage of semi-conductors, or cost explosion in international freight following a global pandemic. This gives the impulse for firms in these sectors to raise prices in order to protect their margins from rising costs. Given the tight supply situation, some firms will enjoy temporary market power and be able to raise prices even further. Firms further down the supply chains then respond by raising their prices given higher costs for inputs and intermediate goods and services, thereby propagating and amplifying the original inflationary impulse. In the final stage, workers see their real spending power eroded by high inflation and react by demanding higher wages and going on strike. This could lead to the emergence of a wage-price spiral which further fuels inflation. At the same time, the system is exposed to further shocks, as was the case in Europe where the energy price spike of 2022 followed the Covid disruptions of 2021.
The key element of the theory is that firms are not only increasing prices in order to pass on higher input costs, but that temporary market power allows them to expand profit margins beyond this level. This is further helped by the fact that crisis narratives convince consumers that higher prices are justified due to recent shocks, such as the Covid-19 pandemic or the war in Ukraine.
The key question then is: does the theory hold up to the data?
The answer to this question is somewhat dependant on the profit measure one looks at. The Office for National Statistics (ONS) recently published the latest data on the net rate of return for private non-financial corporations, showing that profitability on this measures remained stable at 9.7% in Q4 2022, the same level it also stood at in Q1 2020. However, looking at gross operating surplus as a proxy for firms’ profits, shows that profits have risen precipitously over the past two quarters, up 8.5% in Q4 of last year and 10.8% in Q1 2023 albeit in current prices. Anecdotally, this chimes well with reports of UK oil and gas firms posting record profits. More recently, food producers and consumer goods giants have also come under scrutiny as firms such as Unilever post bumper profits.
Nevertheless, given that corporate profits have shown only a recent uptick and that wider profitability ratios have actually remained flat throughout 2022, it would be hard to argue that sellers’ inflation has been a major factor behind UK inflation over the entirety of the past two years. However, it might well be a good explanation for inflation falling back more slowly in 2023 than anticipated. Food price inflation in particular has surprised to the upside in the UK and other European countries, despite prices for raw materials falling for most of 2022. In Italy, pasta prices soared about twice the rate of headline inflation in March and April, despite wheat prices falling. This caused enough of an uproar for the government to convene an emergency pasta summit. In the UK, too, the government organised a meeting with representatives from various stakeholders of the UK food supply chain to investigate if excessive profit taking might be responsible for high rates of food inflation.
Ultimately, the increased public attention will be part of the solution to bring inflation down. As energy prices have fallen back to pre-war levels and supply chain disruptions ease, firms will find it more difficult to blame higher prices on global disruptions. And as households still suffer with falling real incomes, patience for firms that bolster profit margins at the expense of consumers will wear thin quite quickly. Politicians are already finding it difficult to resist the temptation to intervene in markets so they can reap the praise for falling prices as recent talk of price controls In the UK has shown.
In summary, sellers’ inflation is an interesting addition to the range of potential explanations for inflation, even though the evidence suggests that in the UK it’s likely only been a factor for the past two quarters. In the absence of new shocks, we expect firms to take note of the public pressure and return to more cautious pricing going forward.
Figure 1: GDP by income, current prices, quarterly growth in %
Source: ONS, GDP First Quarterly Estimate, Q1 (Jan to Mar) 2023
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