Paul Donovan: UBS chief economist unwraps profit-led inflation

Of Interest

If you're looking for profit-led inflation you should probe consumer facing industries rather than look across the whole economy, says UBS chief economist Paul Donovan.

Speaking in the Of Interest podcast, the London-based Donovan says profit-led inflation, whereby companies are able to expand profit margins and convince customers it's fair to do so, is the third wave of inflation experienced in developed economies since the Covid-19 pandemic. It follows a demand shock as developed country economies reopened and consumers had a "stockpile of savings" they spent on durable goods such as furniture, electronics and cars, and an energy supply shock after Russia invaded Ukraine, energy prices surged and demand reduced.

"What it [profit-led inflation] has really done is prolong the inflation. If we had not had the war in Ukraine I don't think we'd have got the profit-led inflation because Ukraine has been an important part of the story that companies have told to convince people to accept higher prices. I think if we hadn't had the war in Ukraine we would be sitting here talking about falling prices today," Donovan says.

"Right now we're starting to see profit-led inflation be challenged in a number of countries. But I'd say that it has probably accounted for about half of the inflation that we've experienced over the last six-to-eight months."

Lobby group Business NZ issued a report itcommissioned from consultants this week on profit-led inflation, or "greedflation" as it put it, saying it was "an imported narrative not supported by the evidence." Looking at data from 14 industries over the three years to December 2022, the report said 71% of price increases came from input costs, 15% labour costs and 14% gross profit increases.

Donovan says three years is too long of a period to look at for profit-led inflation, and you wouldn't expect to see it across the economy as a whole.

"I think this is one of the problems with a lot of the analysis that we've seen on profit-led inflation. There is this assumption that every company is raising profit margins and that absolutely isn't the case, it's a subset of companies that raise margins. And so if you look at economy-wide data you're going to find less evidence of profit-led inflation," says Donovan.

"In the case of New Zealand, if you're going to get profit-led inflation coming through, you don't look at the entire economy, you look at the consumer facing sectors [such as retail, restaurants, clothing brands or food brands], and see what's happening with margins there. That's the critical story."

In the podcast he also talks about how to spot profit-led inflation, consumers' naive views about what causes inflation, why he doesn't like the greedflation term, why central bankers should talk more about profit-led inflation, why it took off in the wake of Covid-19, and the role of social media.

"Two things made profit-led inflation easier this time. Consumers did have more savings, sort of a windfall of savings during the pandemic. No one's going to describe the pandemic as a lottery win but it was a bit like that. You got a sudden influx of cash that you weren't expecting to have. So that meant that people perhaps became a little bit more indifferent to prices," says Donovan.

*Donovan published a report on profit-led inflation earlier this year which we covered here.
*And you can find all episodes of the Of Interest podcast here.