Are profits driving inflation?

Inflation has been above the 2% target since August 2021, averaging 9.3% in the first half of 2023. Inflation was first driven up by pandemic-related supply chain frictions, and then by energy and other commodity prices, exacerbated by the war in Ukraine. The role of external factors in driving UK inflation over the past three years is now fading, but domestic price pressures have strengthened, with core CPI inflation, services price inflation and wage growth close to multi-decade highs. One suggestion is that rising prices are being driven by growth in companies’ profit margins, but at the macro level the evidence does not support this. If anything, CBI business surveys suggest that a squeeze on profits has worsened in recent months, which may be prompting some firms to put investment plans on hold.

Inflation is increasingly being driven by domestic price pressures

Recent inflation data have underlined the diminishing role of imported inflation, following the twin shocks of pandemic-related disruption (on goods prices) and the war in Ukraine (which caused energy and food prices to spike). Falling fuel prices and slower annual food price inflation helped push the headline rate of CPI inflation down to 7.9% in June, from 8.7% in May and a peak of 10.1% in October 2022. And headline inflation is expected to slow further in the coming months, partly because lower wholesale energy prices paved the way for a significant cut to household electricity and gas bills from July.

By contrast, the importance of more domestically generated price pressures has grown. While goods inflation (more heavily influenced by global factors) peaked in October 2022 at 14.8% and has since come down sharply to 8.5% in June, core inflation (excluding food and energy) and services inflation continued to rise through much of 2023, from 6.5% and 6.3% last October, respectively, to 6.9% and 7.2% in June. This is clear evidence of “second round effects” at work, as workers seek to restore purchasing power through higher wages and companies try to rebuild their profit margins. The link between strong wage growth and high core and services price inflation is clear, but what can we say about the role of profits in driving prices higher?