I’m not pushing some bolshevik agenda here. The mechanics do matter. If price increases led us into inflation, then price cuts might just lead us out? A downward spiral of price-cutting would be great for inflation, consumers, and the economy as a whole. It would suck for profit margins (and stock prices) in sectors that can’t maintain informal price discipline. I am pretty sure Tech comes out OK. I’m not too clear on what sectors would get hit.
The paper below (pretty convincingly) puts much of the blame for the recent inflation on informally coordinated price increases in key industry sectors. The “emergency” of COVID created PR/political cover to organize those implicit cartels…
The dominant view of inflation holds that it is macroeconomic in origin and must always be tackled with macroeconomic tightening. In contrast, we argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. 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 sector-wide cost shocks and supply bottlenecks.
The good news (for the economy) is that price coordination eventually breaks down in informal (or even formal) cartels. Price discipline cracks. Someone starts discounting.
Arguably the great yearning for a sharp labor market recession is to avoid that collective breakdown. Once price discipline breaks down, it can turn into a race to the bottom. If firms can’t count on wage suppression to cushion the blow…
- FYI – It is an open secret that earnings calls are a great mechanism for price-signalling to other industry players. You can coalesce that informal cartel openly with no legal risk. But please don’t EVER mention that in polite company. 🙂
The paper also says out loud the unspoken reason – distraction! – so many people are so eager to over-focus on monetary policy and labor market drivers of inflation. They desperately want to avoid talking about Real Economy price-setting & supply/demand dynamics.
That conversation might lead to uncomfortable questions of just how competitive our “free market system” really is. People might also start asking whether crushing the labor market is really the right solution to a problem created on the price-setting side of the inflation equation – Price = Profits + Costs (Labor, Capital, Land).
I keep poking at the consensus narrative around inflation because a lot of it sits on shaky foundations. Most investors have unshakeable confidence in a set of monetary policy folk beliefs that have remarkably little support in real world economics or real world data. I’m not trying to push some bolshie political agenda here. I’m just trying to get a little closer to the truth than the stuff “everyone thinks is true.” Seeing a little further towards the truth is kind’ve my day job.
Collective delusions can last for a long time (as I have learned to my pain). But they, like informal cartels, eventually break down. Reality asserts itself – most likely here in the form of lower profit margins. Possibly also higher wages, and a stronger Real Economy circular supply/demand dynamic than most expect.
So what industry is most vulnerable to a race to the bottom? I don’t really know and, judging from price action – the markets aren’t too sure either.
- Definitely not Tech (my specialty). Prices are already high and protected by other barriers to entry. 🙂
- Durable goods?
- High fixed cost industry sectors – airlines?
- Consumer goods in general (discounts and sale offers have started pouring into my inbox after a 2 year absence).
The above was sparked by a question asked in an FT newsletter. For context, it is below.
It is natural to conclude that the post-GFC margin spike is somehow explained by monetary policy, given that after 2010 policy rates were pinned down and the Fed balance sheet growing. It is not clear to me exactly how this would work, however (remember operating margins are calculated before interest expense). Furthermore, there are other explanations available. Are companies underinvesting, boosting profits (and management pay) at the cost of future growth? This is the view of the economist Andrew Smithers. Or perhaps industry has become less competitive, allowing companies to pad margins without giving up market share? Or perhaps companies have had the upper hand against workers in recent years?
Full abstract of the paper.
The dominant view of inflation holds that it is macroeconomic in origin and must always be tackled with macroeconomic tightening. In contrast, we argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. 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 sector-wide cost shocks and supply bottlenecks. We review the long-standing literature on price-setting in concentrated markets and survey earnings calls and compile firm-level data to derive a three-stage heuristic of the inflationary process: (1) Rising prices in systemically significant upstream sectors due to commodity market dynamics or bottlenecks create windfall profits and provide an impulse for further price hikes. (2) To protect profit margins from rising costs, downstream sectors propagate, or in cases of temporary monopolies due to bottlenecks, amplify price pressures. (3) Labor responds by trying to fend off real wage declines in the conflict stage. We argue that such sellers’ inflation generates a general price rise which may be transitory, but can also lead to self-sustaining inflationary spirals under certain conditions. Policy should aim to contain price hikes at the impulse stage to prevent inflation from the onset.