The fat cat myth: Who should we really blame for high inflation?

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The persistently high inflation rates in the post-pandemic period have generated accusations of corporate greed, price-gouging and inflated profit margins as a major contributing factor. However, it might be governments and their central banks, rather than corporates, that are to blame.

A US Federal Reserve Board research paper released last week undermines the argument that the surge in inflation rates last year to levels not seen for decades was due to “greedflation,” as some have described the charge that companies took advantage of the pandemic and the global supply chain dysfunction to increase their prices beyond what could be justified by increased labour costs and input prices.

Companies around the world have been accused of taking advantage of the pandemic and the global supply chain dysfunction to increase their prices.Credit: Joe Armao

The Fed’s paper found that US non-financial corporate profit margins (based on pre-tax profits with an adjustment for depreciation) did increase quite sharply, to about 19 per cent in mid-2021 but fell back to 15 per cent by the end of 2022.

That compares with margins of about 13 per cent immediately before the pandemic and is at odds with what would normally occur in an economic downturn of the severity of that which accompanied the pandemic.

The Fed’s analysis, however, also found that the increase in aggregate profits margins could be attributed to the unprecedented direct government interventions to support small and medium-sized businesses and the large reduction in net interest expenses as the Fed slashed interest rates to zero.

“Once we adjust for fiscal and monetary interventions, the behaviour of aggregate profit margins appears much less notable and, by the end of 2022, they are essentially back to their pre-pandemic levels,” the research report said.

As occurred in most developed economies, in response to the outbreak of the pandemic the US provided unprecedented support for its businesses and people in 2020 and 2021, injecting large amounts of cash into businesses and households, while the Fed itself cut interest rates, resumed quantitative easing (buying $US95 billion ($148 billion) a month of bonds and mortgages) and injected vast amounts of liquidity into the US financial system.

The CARES Act, the Paycheck Protection Program, the Health Care Enhancement Act and the American rescue Plan – analogous to our JobKeeper, JobSeeker, Job Maker and other pandemic business assistance programs – essentially subsidised businesses’ non-labour costs and boosted their profits and margins.

The Fed’s research paper says that between 1980 and 2019 the government-related component of non-labour costs fluctuated between 8 and 10 percentage points, averaging 9.4 percentage points. In the second quarter of 2020 – as the pandemic developed – that dropped to 3.8 percentage points.

Between the fourth quarter of 2019 and the end of 2022, there was also a rapid decline in interest costs as companies refinanced at the lower rates, which the paper says contributed to a one percentage point increase in profit margins.

Outgoing RBA governor Philip Lowe.Credit: Alex Ellinghausen

Those two factors – subsidies and inflation rates – effectively account for the entirety of the increase in margins and, with interest rates having risen sharply over the past 18 months and the pandemic-era subsidies having ended, margins could be expected to have gradually returned to their pre-pandemic norms, which seems to have occurred in a strongly-performing US economy.

Is the US experience reflective of what occurred in Australia?

A Reserve Bank analysis earlier this year came to similar conclusions, finding that the profit share of income in Australia was little changed by the pandemic – if the mining sector is excluded.

A surge in iron ore and coal prices during the pandemic, and a big spike in oil and gas prices as the war in Ukraine started, distort the overall picture.

They should be excluded from discussions about companies’ impact on domestic inflation because they predominantly export their output, their prices are set by global supply and demand balances and they have only a limited impact on domestic prices.

The RBA found that the aggregate profit share of non-mining companies had changed little over a decade, although the profit share at the end of 2022 had been slightly higher than in pre-pandemic 2019 but had been falling through the year to be below its average level of the past decade.

The RBA and Fed conclusions fit with a CommSec analysis of earnings in the 2022 and 2023 financial years.

In 2021-22, CommSec calculated that the aggregate revenues of the 158 ASX 200 companies (including resource companies) that had reported had risen 10.6 per cent, with 87 per cent of the companies increasing their revenues.

A surge in iron ore and coal prices during the pandemic, and a big spike in oil and gas prices as the war in Ukraine started, distort the overall picture.Credit: Michele Mossop

The size of the average increase in revenues was an impressive, or disconcerting, depending on your perspective, 34.5 per cent and the increase in aggregate profits of 56 per cent (about 36.5 per cent if BHP were excluded) equally so.

Aggregate expenses, however, rose 8.6 per cent, so the increase in profit margins was about two percentage points.

The same analysis this year found that aggregate revenues for companies reporting for their full financial year (again including resource companies) rose 8.9 per cent but expenses jumped 13.9 per cent with statutory profits falling 42.9 per cent. That’s a big squeeze on margins.

The pattern is consistent with the Fed’s analysis.

When governments were pumping out stimulus and assistance – the Australian federal government’s extra spending amounted to more than $500 billion and the states also had massive pandemic-related spending programs – and the central banks were cutting interest rates to zero or below, revenues grew, margins expanded and earnings rose.

Once the pandemic-related spending ended and rates began rising rapidly in response to the outbreak of inflation, the rate of increase in costs grew significantly faster than the increase in revenues and margins, therefore, contracted significantly.

What these, and other analyses suggest, is that governments probably over-spent in response to the pandemic and central banks probably also did too much, although that’s easy to say with hindsight. At the time, the policymakers were confronted with a once-in-a-century challenge of then unknown but frightening dimensions.

What was apparent from the most recent round of financial results is that, even with supply chains now functioning reasonably normally and the US and Australian economies now operating within a slowing global economy, margins have been contracting by more than they grew during the pandemic years.

To the extent that there might have been some pockets of “greedflation” in sectors where demand greatly exceeded pandemic-disrupted supply and companies were able to/needed to demand high prices for their products and services (aviation, for instance), the lower rates of economic growth, the continuing normalisation of supply chains and increased competition will continue to erode those companies’ pricing power.

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