Wall Street braces for the end of profit-led inflation

Companies are losing their ability to keep prices elevated as inflation has been coming down, and Wall Street is noticing.

Inflation was initially caused by companies passing through cost increases brought about by mangled global supply lines. Those elevated costs gave them cover to keep their prices higher and take more in profit.

But as inflation has been coming down and consumers have been getting hip to the profit-led phase of inflation, private-sector pricing power is diminishing.

Median inflation expectations fell to 3.5 percent for the year ahead and to 2.9 percent for the next few years, according to the July Federal Reserve’s Survey of Consumer Expectations, with price expectations for food, medical care, and rent dropping to their lowest level in more than two years.

“It used to be, ‘Hey, pricing is really strong. We’re going to go out, we’re gonna pass it through, and we’re going to keep it going. We’ve got the ability to do that because of the cost environment,’” Lori Calvasina, head of U.S. equities at RBC Capital Markets, said on the Bloomberg television network earlier this month.

“Now what I’ve noticed is that a number of companies in different industries are saying things like, ‘Well, the cost environment is getting better. Inflation is coming down and pricing, you know, with it,'” she said.

“I do think the tone on pricing has changed dramatically from what we’ve seen over the past year or so,” she said.

A long-term global trend

U.S. profits have been falling over the past few quarters in both absolute terms and as a share of prices, but profits within the economy overall are still way higher than they were before the pandemic.

That’s even as the portion of the economy devoted to paying American workers has come back down.

There’s an increasing amount of commentary about a “choosier and pickier consumer, consumers who are starting to push back,” Calvasina noted.

Surging profitability has aligned with higher inflation internationally, as well.

The United Nations noted in July that profits of nearly 4,000 big international companies stayed below $3 trillion — or 6 percent of revenues — in the decade before the pandemic. But profits jumped closer to $4 trillion — or around 8 percent of revenue — in 2021 and 2022.

That follows a longer-term trend in the economy, in which the average profit rate has increased from 1 percent to 8 percent over the last 40 years, according to an influential 2020 study published in the Quarterly Journal of Economics.

Increases in markups have been outpacing increases in overhead costs, the authors of the study found, attributing the big-picture trend to companies growing more powerful.

What the Fed thinks about higher profits

Profits, prices and inflation are also linked together in the Federal Reserve’s thinking, though open discussion of the economy’s profit rate by the Fed rarely happens.

“Higher profits and higher margins are what happens when you have an imbalance between supply and demand,” Federal Reserve Chairman Jerome Powell said during a May press conference.

“We’ve been in a situation in many parts of the economy where supply has been fixed or not flexible enough. And so, you know, the way the market clears is through higher prices,” he said.

A majority of Americans are blaming inflation on higher profits, according to a survey conducted in June by U.K. polling company YouGov that sampled 1,000 U.S. citizens.

In that poll, 61 percent of respondents selected “large corporations seeking maximum profits” as deserving of “blame” for inflation — the highest number for any single category.

Fifty-five percent said federal spending and the price of foreign oil should be blamed, 52 percent pinned inflation on the pandemic, and 45 percent believed supply chains were the problem.

The international nature of the inflation was recognized by 69 percent of respondents.

In the U.K., economists have noted that publicity about profit-driven inflation and the encouragement of consumers to do less shopping has had a positive effect on reducing prices.

“Publicity around profit-led inflation seems to have had an impact, with consumers rebelling against margin-expanding price increases,” UBS economist Paul Donovan wrote in a commentary earlier this month.

A ‘normal part of business’ for good?

But some companies have altered their entire business models to accommodate margin expansion. The practice is seen across industries including auto manufacturing, airlines and hotels.

The auto manufacturing sector in particular, which went through its own inflationary cycle toward the beginning of the pandemic due to component shortages, has embraced a lower-volume, higher-margin shift.

“As we’re working through this lower inventory and these opportunities that we’re seeing today, we’re working on how we make them a normal part of our business as we go forward,” John Lawler, Ford’s financial boss, said in 2021.

Daniil Manaenkov, an economist with the University of Michigan who studies the auto industry, told The Hill earlier this year that the pandemic had pushed automakers into a “different equilibrium.”

Consumers are still concerned about inflation, with 95 percent of respondents in the YouGov poll saying the issue was either “very important” or “somewhat important” to them.

New York City resident Gina DiStefano told The Hill she is frequently looking for deals and lower prices.

“I kind of live by couponing more than I had been,” she said. “I’d say rent is pretty tough.”

While the role of profits in the current inflation have been a source of controversy among economists, the debate has an inherent taboo within market economies that has long been recognized by authorities.

“Our merchants and master-manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both at home and abroad. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people,” British economist Adam Smith wrote in 1776.