More on Inflation and Profits

Over the past few months, various authors at various institutions — specifically Oscar Arce, Elke Hahn and Gerrit Koester at the ECB, Andrew Glover, José Mustre-del-Río and Alice von Ende-Becker at the Kansas City Federal Reserve, and Paul Donovan at UBS — have written pieces about the relationship between profits and the most recent bout of inflation. Advocates of what is often called the “greedflation” hypothesis of inflation have taken to pointing to these pieces as proof of that hypothesis.

Assessing whether these pieces prove the greedflation hypothesis is initially complicated by the fact that the greedflation hypothesis remains a bit unclear.

Causing Inflation vs. Benefiting From Inflation

Inflation is, definitionally, an increase in consumer prices. This increase results in more business revenue and then that revenue winds up distributed out to workers as higher wages or to owners as higher profits.

Sometimes advocates of the greedflation hypothesis appear to simply be saying that more of the revenue from increased prices is going to higher profits than to higher wages. But this narrow version of the hypothesis is not actually a hypothesis about the cause of inflation. It’s a claim about how the revenue gains from inflation are being distributed within firms.

At times, it seems like some advocates of the greedflation hypothesis simply do not understand that there is a difference between what causes inflation and who benefits from inflation. I guess this confusion is understandable to some degree but it’s not that difficult to clear it up.

For an example of the difference, consider the case of rental housing in Williston, North Dakota in the mid-2010s. Due to a nearby oil boom, Williston saw a huge influx of highly-paid oil workers. This influx more than doubled the town’s population over a few years and pushed rents up so high that Williston briefly had the highest rents in the nation. This housing price inflation resulted in windfall profits for the incumbent owners of Williston’s housing stock, but it was a massive spike in housing demand resulting from the influx of highly-paid oil workers that “caused” the inflation, not the windfall profits of incumbent Williston housing owners.

At other times, advocates of the greedflation hypothesis appear to be saying that firms are pushing up prices for no particular reason other than they want more profit. This theory actually functions as a hypothesis of inflation because it doesn’t merely look at who benefits from inflation. It actually provides a theory of price increases that emanates from the greedy intentions of corporate executives.

Do the recent publications from the ECB, KC Federal Reserve, and UBS actually support this theory? I’ve read them and they really don’t.


The ECB publication explains the inflation in the euro area this way:

Inflation in the euro area has been high recently, mainly because of a surge in energy prices. Since the euro area imports more than half of the energy it uses and energy has become much more expensive, households and firms have lost real income. This has been made worse by supply chain problems which have also driven up import prices. In such a situation, firms have an incentive to try to minimise their share of the burden by raising their prices in order to protect their profit margins. Producers in some sectors might even try to increase their margins over and above what would be justified by higher input costs to also fully recoup previous real income losses from the various shocks of the past three years. Another motivation could be the attempt to build buffers in an environment of high uncertainty.

Here, the authors clearly point to higher energy prices resulting from the Russia-Ukraine war and supply chain problems as the causes of inflation. They then explain that these price shocks could result in firms increasing their margins in order to recoup losses from the shocks in prior accounting periods and to provide a financial buffer against the possibility that similar shocks will cause losses in future accounting periods. In this telling, the expansion of profit margins is serving an income-smoothing function for firms in the face of inflationary shocks.

The reason greedflation advocates seem to think that the publication is saying profits are driving the inflation is because, a few paragraphs later, the authors write:

So what does actually drive up inflation, profits or wages? The contribution of wages and profits to domestic price pressures in the euro area can be assessed based on the GDP deflator. […] In the fourth quarter of 2022, year-on-year growth of the GDP deflator picked up further, to 5.8%. This highlights workers’ and firms’ strong reactions to energy and input cost pressures and shows that the intention to offset real income losses became a driver for higher inflation. The latest increases in the GDP deflator have been driven by both unit labour costs and unit profits. Unit profits increased by 9.4% in the fourth quarter of 2022, year-on-year, and contributed more than half the domestic price pressures in that quarter, while unit labour costs increased by 4.7% and contributed less than half.

The wording of this paragraph makes it sound like the authors are trying to suss out whether wages or profits “caused” the inflation. But they aren’t. They continue to argue that responses to energy and supply chain shocks are causing the inflation but also decide to see who is most benefiting from that. As discussed already above, who benefits from inflation is not the same thing as what causes inflation. These authors understand this, but their sloppy wording makes it easy for others to misunderstand it.

Indeed, they continue just a few paragraphs later on this question:

Many companies are apparently able to expand their profit margins without facing significant losses of market shares. Why is that? The first reason is demand outpacing supply in many sectors: surging demand for certain goods and services after the pandemic met the widespread supply constraints of firms that are finding it difficult to get sufficient raw materials, intermediate goods, equipment and workers. High input prices (for example for energy) also made it easier for firms to increase their profit margins, because they make it harder to tell whether higher prices are caused by higher costs or higher margins. And since, as highlighted above, companies aim to recoup their real income losses whenever possible, the high inflation environment can provide a further opportunity to do so.

Once again we get high input prices, especially energy, as a cause of inflation and we get an explanation for profit margin expansion centered on recouping income losses from prior accounting periods. They also add into the mix a straightforward excess demand cause for inflation.

These ECB authors may or may not be right about what’s causing inflation in the euro area. But they aren’t arguing for the greedflation hypothesis and they don’t provide any support for it.

KC Federal Reserve

The KC Federal Reserve publication actually makes one of the same arguments that the ECB publication makes. Specifically, the authors argue that profit margin expansion reflects firms trying to buffer themselves against future inflationary shocks. Indeed, in reaching this conclusion, they specifically reject the market power mechanism many greedflation advocates have used to explain how companies can increase prices for no particular reason without losing customers:

Although our estimate suggests that markup growth was a major contributor to annual inflation in 2021, it does not tell us why markups grew so rapidly. We present evidence that the timing and cross-industry patterns of markup growth are more consistent with firms raising prices in anticipation of future cost increases, rather than an increase in monopoly power or higher demand. First, the timing of markup growth in 2021, as well as earlier in the pandemic, does not line up neatly with the spike in inflation during the second half of 2021. Instead, the largest growth in markups occurred in 2020 and the first quarter of 2021; in the second half of 2021, markups actually declined. Therefore, inflation cannot be explained by a persistent increase in market power after the pandemic. Second, if monopolists raising prices in the face of higher demand were driving markup growth, we would expect firms with larger increases in current demand to have accordingly larger markups. Instead, markup growth was similar across industries that experienced very different levels of demand (and inflation) in 2021.

In fact, the authors actually reject the greedflation hypothesis by name on page eight:

Although markup growth was high in 2021, the evidence from the previous section casts doubt on the simple explanation of “greedflation,” understood as either an increase in monopoly power or firms using existing power to take advantage of high demand. Instead, this evidence may be consistent with an alternative explanation: that firms are raising markups in the present to smooth price increases they expect in the future.

As with the ECB authors, these authors may or may not be right about the cause of inflation in the US. But they very explicitly aren’t arguing for the greedflation hypothesis.


Unlike the ECB and KC Federal Reserve publication, the UBS publication does actually make a greedflation-type argument. Before getting into that argument, it is worth noting that the UBS publication is not the same kind of thing as the other two. It’s very brief musings from the UBS chief economist, Paul Donovan, not deep research in the ordinary sense. This doesn’t mean it’s wrong. But it’s useful to take it for what it is and not put more weight on it than the author himself probably wants you to.

In any case, Donovan begins his brief note by arguing that we have seen three discrete waves of inflation. The first wave “was a fiscally fueled, demand-led inflation,” i.e. demand exceeding supply caused price hikes. The second wave was a “commodity inflation” caused primarily by a rise in energy prices resulting from the Russia-Ukraine war (ECB said the same thing). The final wave was “profit-led inflation,” which resulted from firms being able to trick consumers into believing that price hikes were fair and should be swallowed by consumers. This last wave is the greedflation wave.

Note that even Donovan rejects the greedflation hypothesis as an explanation for the earlier bits of inflation that we saw. This means that, if you think Donovan is right, then you must think that greedflation advocates have mostly been wrong about the years of inflation we have seen.

Although Donovan’s “profit-led inflation” theory is a greedflation-type theory, I don’t think most greedflation advocates actually agree with the specifics of it and probably don’t agree with his amusing solution to it.

According to Donovan, there are two types of companies in this world: companies that have one-off customers and companies that have repeat customers.

For companies that have one-off customers, like used-car dealers, building loyalty and a good long-term relationship does not matter. Thus, these companies will always try to extract as much profit as they can at any given time, meaning that their price-setting will largely reflect real-time supply-and-demand dynamics

For companies that have repeat customers, like a grocery store, building loyalty and a good long-term relationship does matter. Thus, these companies will have to balance maximizing their day-to-day prices against retaining customers by seeming to have stable and fair prices.

The reason the repeat-customer businesses have been able to engage in profit-margin-expanding price hikes is that the demand-led and commodity inflation that occurred in the first two waves made it so that the companies could “spin a story” that they had to increase prices. Since the customers do not realize that this is a lie, they don’t rebel and just swallow the price increase because they think it is “fair.”

Donovan goes to great pains to say that this particular inflation is not driven by market power (“The family-run shop is just as capable of ramping up its profit margin as is the national chain”) but is instead driven solely by businesses persuading ignorant consumers that the price hikes are fair and should be paid. Thus, Donovan’s solution to this kind of greedflation is simply to get consumers to stop believing that the price hikes are fair and thereby stoke the consumer rebellion that the repeat-customer businesses are sensitive to.

So ultimately, Donovan’s version of “greedflation” is really a theory that, recently, repeat-customer businesses have been taking advantage of ignorantly loyal customers who are accepting price increases (instead of complaining about them or switching to a competitor) because they think the price increases are fair in light of the prior two non-greedflation waves of inflation.

Donovan doesn’t muster any real evidence in favor of this hypothesis, but it is certainly an interesting theory and I suppose you can’t rule it out. But the idea that this is some kind of slam dunk for greedflation advocates is pretty silly.