UBS Chief Economist suggests social media could help combat profit margin-led inflation

Arguing profit-led price rises is the third wave of inflation experienced in so-called developed country economies since the Covid-19 pandemic, UBS Chief Economist Paul Donovan suggests social media could help combat it.

The UK-based Donovan describes the first two waves of inflation as transitory inflation for durable goods, and commodity inflation. The third is profit margin-led inflation.

"Profit margin-led inflation is not caused by a supply-demand imbalance. Profit margin-led inflation is when some companies spin a story that convinces customers that price increases are 'fair,' when in fact they disguise profit margin expansion," says Donovan.

"Technically, companies are able to use stories to reduce their customer's price elasticity of demand."

Donovan says many developed economies are experiencing profit-led inflation in specific sectors of the economy citing the UK milk market as a recent example.

"This is not about profits rising on the back of strong demand. Profit-led inflation occurs with more or less stable demand, but in circumstances where consumers are persuaded that the price increase is 'fair' or 'justified.' Companies pass on costs and an increase in margin," says Donovan.

"Recent inflation has been driven by an unusual expansion of profit margins. Profit margin-led inflation occurs when companies tell their customers a convincing story that lets them raise prices without significantly reducing demand. It is inflation driven by spin, not substance."

Other examples he cites where "stories are being spun to present price increases as 'fair'," include supply chain disruption, labour shortages, and “general inflation.” And it's not just big companies that pull the wool over consumers' eyes.

"While large companies are often, rightly, criticized for this profit-led inflation, it can just as easily be small businesses. The family-run shop is just as capable of ramping up its profit margin as is the national chain. It is also more likely to be retail customers that are convinced to accept higher price increases. Higher up the supply chain, corporate purchasers are more likely to be aware when price increases are not fair," Donovan says.

"The leap up in US retailers’ profits as a share of GDP is exactly what is expected in a profit-margin inflation episode. For over a decade, pricing power was moderate, and the amount of profit retailers took was fairly steady. But in the second quarter of 2021, as the economy reopened, US retailers were able to persuade consumers to accept far higher prices. At the same time, retailers were able to keep down wage costs, and so profit margins exploded."

Central banks & 'greedflation'

In terms of pointing the finger at profit margin-led inflation, Donovan isn't alone. Albert Edwards, the London-based Societe Generale Global Strategist, is also doing so. However, he calls it "greedflation," noting it has come to the attention of both the European Central Bank (ECB) in this article, and the US Federal Reserve, albeit they didn't call it greedflation.

Edwards argues corporate greedflation is "a vitality important topic" for both equity and bond investors.

"For equity investors, if companies have used the 'cover' of supply constraints from the pandemic and the war in Ukraine to raise output prices well beyond what is justified to maintain margins, that is great news at the stock level. On the other hand if the higher inflation that results from companies expanding margins causes higher consumers price index inflation then the central banks will likely raise rates higher for longer risking a hard [economic] landing and financial market turmoil, which is not such good news for equity investors!"

"Up until recently, policy makers when they have commented in public about the need for restraint, have always focused on households demanding higher wages - warning that this would result in inflation becoming entrenched. These claims are ridiculous as households have suffered huge real wage cuts. It is companies that are driving inflation higher but this has been something central bankers seem loath to mention. Far easier to call for 'pay restraint'!" Edwards says.

"I sense the tide is turning though. Fed officials have recently commented on greedflation, of course they didn't use that actual word - too controversial."

Edwards argues that over the next year the nightmare scenario for policy makers would be to see the higher for longer mantra driving economies into recession and unemployment rising, yet inflation "falls like a feather having previously risen like a rocket."

"If at the same time corporate profit margins stay resilient, politicians will begin lining up to shout about corporate greed and putting their competition regulators on notice that they want investigations into 'price collusion' to stamp out greedflation. This is not so good for equities," says Edwards.

Two types of companies

Donovan describes two sorts of companies. Some have strong, cyclical pricing power so higher demand means higher prices and higher profit margins. These companies generally depend less on repeat business or customer loyalty.

"If you do not care whether the customer comes back, you will take every opportunity to get as much money from any customer who wants to buy from you," he says.

Used-car prices, Donovan says, are a classic example.

"Buying a used car is generally a one-off purchase. The seller will get the buyer to pay as much as possible for the car. When used-car demand surged in 2021, profit margins on used cars exploded and prices soared. In 2022, as demand eased, the pricing power and profit margin fell back."

"This first group of companies will therefore raise and lower profit margins, and potentially prices, as demand fluctuates. Inflation is demand-driven. This is normal, and it is not what is creating unusual inflation at the moment," says Donovan.

The second group of companies, he says, typically have weaker pricing power. They may have strong brand values and need return customers. For example, any company that issues a customer loyalty card is in this category.

"Ordinarily, these companies pass on cost increases, but they will not expand profit margins. The reason is simple. If consumers feel that prices are rising unfairly, they will desert the company. Consumers who have defected to a rival brand are very hard to win back - loyalty is an expense commodity, which is exactly why loyalty cards offer the rewards that they do," Donovan says.

"Very occasionally, this second group of companies find a way to spin a story that lets them expand their profit margins without creating a consumer rebellion. For some companies, though not all, this is one of those occasions. If a company can use some external shock to justify a price increase, they may also be able to expand profit margin. The result is that inflation today is being driven by an unusual degree of profit margin expansion."

Companies, he argues, can expand profit margins if they can convince their customers that price increases are fair. For this to work, two conditions are required. Firstly, something has occurred that companies can present as being “outside of their control.” And secondly, customers don't understand the companies’ true costs.

"For example, widespread reports of rising agricultural prices allow supermarkets and restaurants to raise the price of food. Years of careful advertising by food producers and retailers have convinced consumers that we live in some kind of rural idyll, where the cost of food is mainly about the farmer. In fact, the farmer gets a tiny share of the price we pay as consumers. Labour after the farm gate is a far more significant cost," says Donovan.

"The consumer hears worrying stories about rising agricultural prices, climate change, and so forth, and feels a food price increase is 'fair.' The fact that most of the price of food is labour costs, and labour costs have not been rising so much, means that the seller is able to raise food prices faster than their costs - expanding their profit margins."

How can profit-led inflation be combated?

Donovan suggests two ways to beat profit-led inflation. Although he argues a general attempt to reduce consumer demand will ultimately weaken profit-led inflation, he suggests this is an inefficient tool to use.

"Profit-led inflation is not driven by rising demand. Rather, it is a relative stability of demand as consumers are made to believe that it is only fair they pay the higher prices that generate the increase in margins. Technically, the story being told reduces the price elasticity of demand of consumers. The risk in profit-led inflation episodes is that central banks focus too much on demand reduction, tighten [monetary] policy too much, and create unnecessary unemployment."

"The alternative remedy for profit-led inflation is when consumers stop believing that price increases are fair, restoring the previous price elasticity of demand. This threatens the customer loyalty for a profiteering company. If consumers believe the price increase is not fair, they will stop buying the product by either delaying their purchase or switching to an alternative supplier. Loyalty card points will not prevent customers moving to another store if they feel they are being 'ripped off' by profit-led price increases," says Donovan.

"Aligned with consumer rebellion is the threat of political involvement. If consumers are upset, politicians are likely to notice. This may then lead to threats of regulation, or a competition inquiry. Political concerns about profit-led inflation have been gradually increasing in volume on both sides of the Atlantic."

Additionally Donovan suggests it's worth considering what social media could do to profit-margin led inflation, noting social media can help companies spin stories justifying price increases.

"Lurid tales of shortages and delays are just the sort of sensationalism that serve as clickbait - the media has effectively boosted the stories that companies want to tell," he says.

Social media power

However, social media can be a double edged sword, also boosting the power of consumers to fight back against price increases viewed as unjustified.

"After enough one-star comments criticizing poor value for money on a review website, the family-run restaurant may reconsider its margin expansion. On a larger scale, if a company is trending on Twitter alongside #boycott, it is time to review its pricing policy," says Donovan.

"A real-world example of this is the Great Cottage Cheese Boycott of Israel in 2011. An increase in cottage cheese prices led to a social-media-orchestrated boycott, which was very effective. Cottage cheese sales fell most aggressively where internet access was greatest. Politicians started to take notice, and within weeks the price increases were reversed."

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