Greed Club: Inflation on the Orient Express
By Martyn Page, Investment Director, Worldwide Financial Planning
May 5, 2023
AVARICIOUS corporate executives, pushy unions, Covid, Vladimir Putin, Brexit voters, central bankers and global warming. All have been blamed for the high inflation that has reduced our living standards. But how much truth is there in these accusations?
Just like an Agatha Christie country house murder mystery, looked at in a certain way everyone appears suspicious. Price stability is dead. Whodunit? As we all know, the earliest suspects, while not entirely innocent, are seldom guilty. Let’s look at them.
The earliest wave of inflation arose from Covid. Supply chains fragmented. Fewer microchips meant fewer new cars and other durable goods. During 2021, some used cars cost more than showroom prices as no new ones were available. That wave has been and gone. When central banks talked about inflation being transitory, let us generously believe they were referring to this.
Then Russia invaded Ukraine and the world was hit by a sharp rise in the price of gas and stunning increases in end-consumers’ bills in Europe and other countries reliant on imported gas. Transportation cost more; restaurant heating bills soared. The war also pushed up the cost of wheat, so food cost more.
Germany belatedly decided it was over-reliant on Russia and set about seeking alternative supplies of LNG while increasing storage and reducing usage. This worked faster than expected, helped by a mild winter.
Such commodity-driven price inflation was the main worry during 2022, with governments borrowing and spending large sums to protect citizens from the worst of the price rises – the scale and timing of price caps also had some technical effects on the calculation of annual inflation. We are still living through this inflation but current signs are that wholesale prices have been falling since the start of 2023. Remember, headline inflation is typically reported monthly with respect to its level a year earlier.
In the murder mystery house, the irascible old colonel from the shires was invariably a too-obvious suspect. In our inflation story, some pointed the finger at Brexit. Now it is true that the pound has weakened considerably since the Referendum but that was nearly seven years ago. A weaker pound does indeed make imports (and foreign holidays) more expensive, so Brexit has definitely weakened our purchasing power.
However, if Brexit was the reason for higher inflation, then the prices of traded goods ought to be rising faster than in Europe. But they’re not. Inflation rates for cars, TVs, food and furniture are lower than in Germany – which has not yet left the EU. Brexit was an act of economic self-harm, but it cannot be blamed for everything and should not distract us. Who then?
As we look around the drawing room, our eyes light upon a suave businessman wearing an expensive aftershave engaged in a heated debate with a trade union leader wearing an angry frown.
The current company reporting season continues to reveal significant profit increases by consumer-facing companies. In a recent trading update, the outgoing boss of Unilever said the consumer goods group was not ‘profiteering in any way, shape or form’ from inflation.
Indeed, no less a person than the Governor of the Bank of England has said there is no evidence for excessive profiteering by companies, but perhaps he has not looked very hard – mobile phone operators have long built in mid-contract inflation hikes to sneak in price rises in an industry where data only gets cheaper. And in the past year, fast-moving consumer goods vendors such as Nestlé, Proctor & Gamble, PepsiCo, Colgate-Palmolive, Reckitt Benckiser and Unilever have regularly reported strong price increases. The first rule of Greed Club is: you do not talk about Greed Club. The second rule of Greed Club is: you DO NOT talk about Greed Club.
How did it begin? Early in the pandemic, some firms found the bottlenecks gave them a temporary monopoly. They used supply chain shocks to raise prices enough to enhance profit margins, amplifying the cost shocks. For example, the chips shortage allowed car makers to focus on expensive, higher-margin models and raise prices without having to fear a loss in market share.
During 2020, Proctor & Gamble managed to increase profit margins above the pre-pandemic level and then keep them there. Selling healthcare and hygiene goods that people depend on gave them space to raise prices. During Covid, people didn’t want to tarry in supermarkets. With one eye firmly on the exit, consumers paid less attention to prices so that they could get out faster.
However, the profit margin-led inflation of the past year exists because companies know customers are more willing to pay higher prices when price hikes are perceived as legitimate. That’s why companies try to spin a story that, regrettably, their price increases are ‘fair’ because of higher labour costs, higher energy bills, higher transport bills, climate-induced shortages, etc.
Profit-led inflation requires customers to believe stories that are not true. Every time the media runs another cost-of-living crisis story it gives greater credence to the corporate spin. These reasons may sound fair but they can also disguise the deliberate expansion of profit margins.
Multinationals have been increasing their profits for decades, so what’s different now? True, such firms are price makers, but they only engage in price hikes if they expect their competitors to do the same. This requires an implicit agreement which can be coordinated by supply bottlenecks and the sector-wide cost shocks listed above. According to the chief economist at UBS, we would typically expect about 15 per cent of inflation to come from the expansion of profit margins. Today, that number is closer to 50 per cent. That’s profit-led inflation. Company bosses have clearly not forgotten the first rule of Greed Club.
Unsurprisingly, the unions, point the finger exclusively at price gouging by large companies. Unite says it is a profiteering epidemic of greedflation, not workers’ wages, that is fuelling the cost-of-living crisis. The union doth protest too much. Small, family-run businesses are just as capable of profiteering as multinationals. Not to mention unions of extremely well-paid, semi-skilled railway workers.
But the unions do have a point. First coined by Ed Miliband in 2011 as a headline-grabbing phrase, the ‘cost of living crisis’ (which referred to the squeezed middle classes traditionally ignored by Labour) has been hijacked to point an accusatory finger at the government, when in fact it deliberately blurs what is a wider problem.
Last year, the Governor of the Bank of England told workers not to push for higher wages because such demands, if achieved, would be a significant cause of inflation. Was he right?
The British wage-price spirals of the mid-1960s and dismal 1970s were in part a consequence of a heavily unionised workforce whose annual pay rises were contractually linked to inflation – the costly Retail Prices Index. We saw how badly that turned out when repeated government attempts to control wages and prices failed to tackle inflation. Today, union power is much less tyrannical, while employees in a larger private sector understand that they only have jobs while their businesses remain profitable. During downturns, they will pragmatically forgo a pay rise in return for keeping their jobs for longer.
Despite the wage deals struck by some unions and the higher wages paid by the private sector to attract talent, real wage growth (ie after inflation) remains calamitously negative – which means falling spending power. Such pay deals – when considered in isolation – look unlikely to create a classic wage-price spiral. And yet, central banks appear to want to create a downturn sufficiently worrying that workers will settle for keeping their jobs and stop asking for higher wages. Something is not right here.
More recently, the Bank of England’s chief economist has said we need to accept that we are all worse off. Despite this not being news to anyone, dyspeptic outrage followed, even though he did not argue that the pain should fall solely on workers. What he meant was that in a situation where nobody tries to lose out, things get worse for everyone.
Furthermore, the workforce has contracted. Before Covid, European workers had returned home. After Covid, the remaining workforce shrank further. People working from home during lockdown re-evaluated their lives. Some retired earlier than planned while others suffered from long Covid and were unable to work.
Faced with a shrinking pool of labour, the private sector – not known for its unionised workforces – increased wages by around six per cent a year to attract candidates. This was not inflationary on its own. Private sector workers were not striking and their higher wages bill could be absorbed by slimmer profit margins. However, tight labour markets might yet mean central banks have to impose higher-than-expected interest rates in order to create the unemployment they believe necessary to get inflation down to two percent. Crude, isn’t it?
Inflation hurts almost everyone. Although there may not be a classic wage-price spiral, higher wages could give the green light to companies to carry on price gouging. And that would be bad for almost everyone – think higher prices, higher interest rates, higher mortgage rates etc. This is what needs to be nipped in the bud – by government and by consumers.
If you wondered why the government delays meeting the unions it’s because every month deferred means inflation should be lower. This makes initial wage demands look increasingly unreasonable and final settlements more affordable. It appears to be working. Government can also reduce overheating by raising taxes or imposing windfall taxes, just as they can cushioning the hit to real wages with energy subsidies.
How can consumers do their bit? Profiteering is not going on all along the supply chain (eg farmgate milk prices remain broadly flat) – just at the end, but profit-led inflation requires customers to believe stories that are not strictly true, so that they are more likely to accept profiteering as being fair. This is the time for the media to re-start the Rip Off Britain campaign, so customers become less willing to accept price gouging and help break the vicious cycle.
You don’t have to be like Howard ‘I’m as mad as hell’ Beale in the film Network. Next time you are shopping, politely tell the Customer Service Desk that the fresh produce they increasingly do not have on their shelves is still too expensive. Please complain; every little helps. Company bosses may begin to wonder whether the short-term gain of pushing up profit margins is worth the long-term risk of customers feeling rip-off resentment or even abandoning them entirely and damaging the reputation of their brand.
Inflation is fundamentally the result of the conflict between firms, workers and taxpayers. It stops only when the various players are forced to accept the outcome. The final adjudicator is likely to be a central bank obliged to clobber the economy, forcing workers to accept lower wages in relation to prices and firms to accept lower prices in relation to wages. Ideally everyone should take a share of the pain, but human nature is not like that. Ask a train driver or a chief executive loaded with share options.
And in answer to the question ‘Whodunnit?’ It was ALL of them.
Martyn Page is the Investment Director of Worldwide Financial Planning which is authorised and regulated by the Financial Conduct Authority.
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