Inflation, Employment costs and Profits: the US evidence

The behaviour of profit margins plays an important role in inflation dynamics. If firms feel that their pricing power has increased they will decide to raise their prices relative to their input costs, leading to higher corporate profits. And if their input costs, including wages, rise, they may decide to lower their profit margins if they feel unable to pass on the cost increase to consumers.

These considerations suggest that the surge in inflation in the US since the onset of Covid, which led to a decline in real incomes for workers, may have been associated with an increase in corporate profits. Rising wage costs can be seen as the consequence of workers seeking to restore their real incomes and may be partially absorbed by a lowering of profit margins to their pre-Covid level.

To explore this topic, pre-tax corporate profits as a share of nominal GDP was used as a proxy for US corporate profit margins. The figure below shows this measure together with inflation over four quarters and the growth rate over four quarters of the Employment Cost Index, which measures wage and other labour costs, in the US.^1,2 Profits are positively correlated with inflation (correlation = 0.4) and negatively correlated with the growth rate of employment costs (correlation = -0.2). 

Figure 1. Profits, inflation and employment costs

Source: EFG calculations on data from FRED. Data as of 01 February 2023.

The figure shows that profits as a fraction of nominal GDP rose from 10.2% in 2020Q1 to a peak of 13.9% in 2022Q2 as prices rose faster than employment costs. Rising employment costs slowed the increase in profitability, which fell to 13.0% in 2022Q3.

The figure below, which runs from 2002Q1 to 2022Q3 shows more clearly the relationship between the growth rate of employment costs in real terms and inflation. It is obvious that there is a sharp negative relationship between these variables (correlation = -0.70). 

Figure 2. Real employment cost growth and profits 

Source: EFG calculations on data from FRED. Data as of 01 February 2023.

To better understand the behaviour of employment costs, prices and profits, a statistical model is fitted on these data.³ Using the model, we can see how the economy responds to economic shocks.

The figure below shows the responses of employment costs and profits to an inflation shock. The immediate effect of the shock is to raise inflation by 0.4%. After two quarters inflation is 0.6% higher, after which it gradually returns to zero. The growth rate of employment costs rises by a little less than 0.1%. This effect rises over time and reaches a little over 0.2% after two quarters and then gradually declines to zero.

The inflation shock thus steadily leads to a decline in real wages. Not surprisingly, profits as a fraction of nominal GDP rise. In the quarter the shock occurs they rise by almost 0.3%, but this effect declines to a little over 0.1% after a quarter. This effect is statistically a little less significant than the other responses.

Overall, an inflation shock is good for firms, whose profits tend to rise, but bad for workers as employment costs rise by less than prices. 

Figure 3. Effects of an inflation shock

Source: EFG calculations on data from FRED. Data as of 01 February 2023.

Next, we turn to an employment cost shock. The figure below shows that such a shock raises the growth rate of employment costs by marginally less than 0.2%. This effect dissipates slowly over time.

Inflation rises in response to the shock, reaching about 0.1% after four quarters. The responses are drawn using a dashed line because the effect lacks statistical significance and the hypothesis that the effect is zero can not be rejected. This is an important finding.

Since inflation does not react strongly to employment cost shocks, it is not surprising that the increase in employment costs lowers profitability. This effect grows over time and reaches 0.2% three quarters after the shock occurs. 

Figure 4. Effects of an employment cost shock

Source: EFG calculations on data from FRED. Data as of 01 February 2023.

Summing up, the key findings of this simple analysis are twofold.

First, variations in firms’ profitability plays an important role in the inflation process by weakening the link, at least temporarily, between employment costs and prices.

Second, there is little evidence that employment cost shocks are important drivers of inflation. Instead, such shocks appear to be absorbed by firm profits. This finding suggests caution when arguing that increases in wages will prevent inflation from declining toward the Fed’s 2% target. Looking ahead it will therefore be important to watch employment costs but more their impact on profitability than on inflation.

¹ Since we are interested in the situation of US firms, we measure prices by the GDP deflator which is an index of prices for goods and services produced in the US.
² Wage costs constitute about two thirds of the ECI and the remaining third benefits (including health insurance, retirement plans and paid time off). See http://go.pardot.com/e/931253/eci-videos-home-htm-/2v3tq/160905801?h=cK81FELeTWt5mK7JGlA395Mh1yVUTDx0HPCw2uXbmTo
³ The model is a first-order VAR, with identification achieved using a Cholesky factorisation, ordering inflation first and profits last.