New Data on Link Between Profits and Inflation

The following commentary is based on a presentation, titled Distributional Conflict and Inflation: Data, Theory, and Outcomes, presented by Jim Stanford at the recent meetings of the Canadian Economics Association at Toronto Metropolitan University in May 2024. The full presentation is available here. The presentation was part of a panel on the role of profits in recent inflation, organized by the Progressive Economics Forum.

By Jim Stanford

Consumer price inflation has decelerated in Canada in the last year, as rapidly as it accelerated in the 2021-2022 period (sparking high interest rates which in turn caused a painful economic slowdown). At last reading (for April 2024), year-over-year CPI inflation had slowed to 2.7% (down from 8% less than two years earlier). That’s within the Bank of Canada’s target range (2% plus or minus a cushion of 1%). And low enough that the Bank cut its policy rate for the first time in this cycle in June.

Many credit the Bank of Canada’s tough monetary medicine for this quick slowdown in inflation. But that assumes that the initial driving force of inflation was too much spending power in the hands of average Canadians. High interest rates, by sucking tens of billions of dollars of purchasing power out of households with debt (like mortgages), reduce spending power and hence (in that theory) solve inflation that resulted from assumed ‘excess demand’.

However, empirical evidence suggests that other factors drove that dramatic but ultimately temporary acceleration in inflation, and hence high interest rates (and the financial challenges they have caused for millions of Canadians) might have been neither appropriate nor necessary to bring inflation down. Both the rise and fall of inflation have been closely correlated with unusual trends in corporate profits in Canada (see figure).

Businesses took advantage of the unique circumstances of the post-lockdown economic re-opening (including disrupted global supply chains, shortages of many strategic commodities, temporary shifts in consumer demand, and a global oil price shock in 2022) to increase their prices far higher than costs, adding substantially to inflation. After mid-2022, when supply conditions began to normalize, corporate profits normalized as well – and so did inflation. There is a very strong correlation between profits per unit of real output in Canada (unit profit cost) and the rate of inflation, but no apparent correlation between unit labour costs (typically held up as the culprit for higher costs and prices) and inflation.

Canadian workers have been ambitious and largely (but not universally) successful in recuperating the real value of their wages, damaged by the initial surge of inflation in 2021 and 2022. Demands for higher wages, backed up with a surge in union organizing and work stoppages, contributed to a modest acceleration in wage growth. By 2023 wages were growing at 4-5% per year (depending on which measure is used), faster than inflation. As a result, real wages have started to grow again – and there is no sign of that trend stopping yet, despite high interest rates, higher unemployment, and a slowing economy.

Indeed, by end-2023, the shift in national income distribution away from wages (and other factor incomes) toward corporate profits that resulted from the burst of post-pandemic profit-led inflation had been largely reversed (see figure). Measured as a share of nominal GDP, workers won back (between mid-2022 and end-2023) almost all of the slice of the economic pie they had lost in the initial inflationary outbreak. The decline in corporate profits (in both absolute terms, and as a share of GDP) since mid-2022 has also largely reversed the increase in the profit share that occurred in the first two years of the pandemic.

This surprisingly quick restoration of factor shares of GDP, alongside the rapid deceleration of inflation in the last two years, attests to the unique and ultimately temporary circumstances that sparked post-COVID inflation (and corresponding distributional shifts). It is also testament to the labour market institutions (including real minimum wage increases in most provinces, sustained trade union density, and an upsurge in work stoppages) that have backed up workers’ defense of their real wages.

Things are not fully back to ‘normal’. Profit margins remain elevated as a share of total revenues. And real wages in some parts of the economy have still been damaged – especially in education and other public services, where intrusive wage suppression efforts by some governments made recent real wage losses all the worse. Real wages in Alberta (where the government has not increased the minimum wage for six years) have fallen faster than any other province. Meanwhile, the macroeconomy continues to stagger under the weight of high interest rates: a monetary policy response that did not address the true causes of post-pandemic inflation, but nevertheless suppressed spending power and aggregate demand.

However, the most recent data suggests that Canada’s structural income distribution is relatively robust. The rapid repair of real wages, and rapid restoration of pre-pandemic factor shares, indicates that workers have power to defend their economic interests – and they have successfully used it. While there’s still work to do to fully repair real wages, that’s something to celebrate.