The first rule of Fight Club is: you do not talk about Fight Club.
Reading the financial press and the freaking New York Times, you would think the only variable in the inflation equation is labor. “We must see unemployment go up to fight inflation…” is stated as some sort of law of physics. It is not. It is an artifact of the stone dead Phillips Curve (see Fed paper below).
Inflation is “prices going up.” The variable in a price equation are Desired Profit Margin + Cost of Materials + Labor Costs + Capital Costs = PRICE.
Labor is the only “acceptable” variable because we must never, ever EVER talk about “Desired Profit Margin.” Even though profits are at all time highs (see Fed Data below).
I’m not making a “political” argument here. Just a practical one. Per the FRED chart, profits are a pretty variable and relatively fast-moving. If something in that price equation is going to give, it is more likely to be profits than (sticky) wages.
The pandemic did wonders for profits because discounting disappeared. Profit margins are still hanging at those pandemic-level highs. There’s a pretty decent chance margins are the last pandemic-era domino to fall – going the way of Zoom and Peloton. See the FRED chart below and forecast out one year – up, flat, or down?.
Wages are sticky and slow to adjust. We also have a labor shortage out there. You gotta keep paying people to produce. There aren’t a lot of people to hire. So you gotta sell on thinner margins.
But why can’t consumers just keep paying current prices? Because their spending depend on their income – their spednign depend on the “labor” share in the Price equation above. The USA took an average 2% pay cut in 2022. Wages are up ~5% on average versus ~7% inflation (so a 2% drop in purchasing power).
That 2% cut has to come out of something eventually (after the pandemic era savings are gone). It is most likely to be profits.
What if we really did cut back on labor and create the unemployment “everyone” sees as necessary? Even fewer people will be able or willing to pay current prices. Profit margins still go down on slowing demand. Slowing employment only makes the profit problem worse.
This is not good for S&P500 earnings. Companies with pricing power will do OK. Companies that have been milking a period of unusual profitability in more competitive markets will do badly. Companies selling durable goods (which sold big during the pandemic) are facing a nuclear winter. When is the reckoning? No idea. But it isn’t going to be pretty for a lot of sectors.
Key point is that, in all this, wages and employment probably take less of a hit than people expect. Mostly because falling profits and falling prices solve the inflation problem before wages do. Sales hold up OK using the labor on hand. It just gets tougher to turn a profit.
Corporate Profits After Tax (without IVA and CCAdj)/Gross Domestic Product – https://fred.stlouisfed.org/graph/?g=1Pik
Fed Paper – Who Killed the Phillips Curve? A Murder Mystery https://www.federalreserve.gov/econres/feds/who-killed-the-phillips-curve-a-murder-mystery.htm
Is the Phillips curve dead? If so, who killed it? Conventional wisdom has it that the sound monetary policy since the 1980s not only conquered the Great Inflation, but also buried the Phillips curve itself. This paper provides an alternative explanation: labor market policies that have eroded worker bargaining power might have been the source of the demise of the Phillips curve. We develop what we call the “Kaleckian Phillips curve”, the slope of which is determined by the bargaining power of trade unions. We show that a nearly 90 percent reduction in inflation volatility is possible even without any changes in monetary policy when the economy transitions from equal shares of power between workers and firms to a new balance in which firms dominate. In addition, we show that the decline of trade union power reduces the share of monopoly rents appropriated by workers, and thus helps explain the secular decline of labor share, and the rise of profit share. We provide time series and cross sectional evidence.
FYI – My New Year’s resolution was “stop sending individual e-mails to individual people when the content is really a perfectly good blog posts.” So I’m going to experiment with more frequent, shorter, and probably less well edited posts 🙂
