Corporate profits were the biggest factor driving up prices last year and will be again in 2023 unless businesses are forced to absorb rising wage bills, the head of the European Central Bank has said.
Outlining how the ECB plans to tackle inflation across the 20-member eurozone, Christine Lagarde said she was concerned that firms would again “test” consumers’ appetite for paying higher prices despite a steep decline in most business costs in recent months.
In a speech at a central banking conference in Portugal, the central bank president said workers were expected to recover the value of their pre-pandemic wages over the next two years, but if companies passed these rises to consumers through higher prices, inflation would persist for longer than currently expected and remain above the ECB’s 2% target.
Warning that there may need to be more interest rate rises this year, Lagarde’s comments were supported by the deputy chief of the International Monetary Fund, speaking at the same conference, who said there was a risk of “inflation getting entrenched”.
Gita Gopinath, who was until last year the IMF’s lead economist, said in her speech that the ECB and other central banks “should be prepared to react forcefully” to signs of persistent inflation, despite concerns that higher borrowing costs could increase unemployment and cause a recession in many countries.
In a study of inflation across European countries, IMF researchers said their findings showed corporate profits had played a significant role in pushing inflation higher across Europe, supporting Lagarde’s concerns.
Citing research by Isabella Weber at the University of Massachusetts, the IMF said: “Rising corporate profits account for almost half the increase in Europe’s inflation over the past two years as companies increased prices by more than spiking costs of imported energy.
“Now that workers are pushing for pay rises to recoup lost purchasing power, companies may have to accept a smaller profit share if inflation is to remain on track to reach the European Central Bank’s 2% target in 2025.
Annual consumer prices in the eurozone rose 6.1% in May, down from 7% in April, while the UK’s inflation rate in May remained steady at 8.7%.
Lagarde said the ECB expected eurozone workers to claw back their earnings losses from inflation by the end of 2025. This would mean a 14% increase in wages over two years.
She said: “During previous [financial] shocks in the euro area, firms had tended to absorb rising costs in profit margins, as slower growth made consumers less willing to tolerate price hikes. But the special conditions we experienced last year turned this regularity on its head.
“The sheer scale of input cost growth made it harder for consumers to judge whether price hikes were caused by higher costs or higher profits, fuelling a faster and stronger pass-through.
“At the same time, pent-up demand in reopening sectors, excess savings, expansionary [government] policies and supply restrictions brought on by bottlenecks gave firms more scope to test consumer demand with higher prices.”
after newsletter promotion
She said corporate profits accounted for about two-thirds of inflation in 2022 compared with the average over the previous 20 years of one-third.
“This in turn led to the shocks feeding into inflation [last year] much more quickly and forcefully than in the past,” she said. To keep inflation low, “we need to ensure that firms absorb rising labour costs in margins”.
Without a shift in corporate behaviour, interest rates would need to stay higher for a longer period than previously forecast, Lagarde said.
“If firms were to regain 25% of the lost profit margin that our projections foresee, inflation in 2025 would be substantially higher than the baseline – at almost 3%,” she added.
The Bank of England has yet to produce a study calculating the influence of corporate behaviour on inflation and says it has no plans to embark on a similar study to the one carried out by the ECB.
The Unite union said the IMF study confirmed research it carried out last year into the impact of rising corporate profits on UK inflation.