Policymakers must tackle sellers’ inflation and prepare for future shocks
The United Kingdom is experiencing an intense cost of living crisis. According to the Office for National Statistics (ONS), between 2021 and the second quarter of 2023 prices have climbed a staggering 17.7 per cent.
They have risen particularly rapidly in basic needs: housing, energy, transportation and food. Fighting this kind of inflation solely by hiking interest rates to decrease demand is inadequate. How far do you have to squeeze people and cool the economy until demand for necessities falls?
The main driver of this inflation is not too much money chasing too few goods. Instead, this is better described as sellers’ inflation.
The corporate sector has managed to protect its margins against massive cost shocks that followed from Covid-19 and the Russian war in Ukraine. In normal times, when a firm increases prices it risks losing market shares. But these sector-wide shocks have co-ordinated price increases as all firms could expect their competitors to follow suit.
To protect their profit margins from cost shocks, firms increase their prices beyond the increase in costs, thus amplifying the initial shock and shifting the price increase on to the consumer. Macro decompositions of the UK price index (GDP deflator) show that 32 per cent of inflation from the first quarter of 2021 to the second quarter of 2023 was accounted for by unit profits, compared with only 22 per cent accounted for by wages, according to calculations based on ONS data.
Some firms managed to not just protect profit margins but substantially increase them. Confirming previous work by Unite, the Bank of England found that overall profit margins in 2023 were at the highest level since 2005, and significantly higher than in 2019. Additionally, firms that already enjoyed the highest profit margins before the onset of inflation managed to increase their profit margins the most.
The Bank of England reports that in 2023: 45 per cent of all UK firms expect an increase in profit margins; 23 per cent anticipate a decline; and the rest expect to see no material change. In contrast, firms that were making losses before the Covid-19 pandemic were worse off in 2022. This is important because rising interest rates put these firms at increasing danger of bankruptcy.
Meanwhile, based on ONS data, real wages have declined by 3.1 per cent between January 2021 and August 2023, and are still 2.6 per cent below what they were just before the 2007 financial crisis. Compared to the first quarter of 2021, the labour share of national income is down by 3.2 per cent, while the profit share increased by 7.9 per cent by the second quarter of 2023, according to calculations based on ONS data. This increases income inequality because most people depend on wages while higher profits benefit a small number of high-income earners. It happens against the background of several decades of weakening bargaining power and rising income inequality. Furthermore, lower income groups spend large shares of their income on essentials that have seen prices shoot up, leaving them even poorer.
Sellers’ inflation requires a new policy approach. More shocks are likely to come. It’s clear shocks to systemically important prices can trigger a cost of living crisis. If we respond to this inflation by hiking interest rates, we risk inducing a recession.
We need disaster preparedness for systemically important sectors like energy, housing, food and transportation. Policymakers must address the question of how to avoid a repetition of the economic meltdown that the UK has just experienced. They need to make essential sectors more resilient so that future shocks do not unleash renewed price explosions that trigger inflation and destabilise the economy.
Where shock absorbers fail, windfall taxes coupled with transfer payments to low-income households, price gouging regulation and emergency price policies can reduce inflation without inducing a recession and exacerbating income inequality.
Isabella M Weber, associate professor of economics at the University of Massachusetts Amherst. Alexander Guschanski, senior economics lecturer at the University of Greenwich.
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