Greedflation, if it ever existed, is correcting itself

In a speech on August 16, US Democratic presidential candidate Kamala Harris called for a federal ban on “price gouging” on groceries. This follows on from President Joe Biden’s proposal for a cap on corporate rent increases, and a longer-standing spate of arguments blaming the inflationary surge of the past few years on rising profit margins and corporate greed. 

Although it is highly doubtful that the pandemic suddenly triggered an upswelling of corporate greed, it is true that in the environment of supply shortages and heightened spending that followed the pandemic recession, firms were able to charge higher markups over costs, and that doubtless contributed to higher inflation.

Nevertheless, rent and price controls are almost never a good idea, and they would be even more misguided at present. Consumer price index (CPI) inflation has already fallen sharply – from 9% in mid-2022 to just below 3% in July – reflecting the recovery of supply chains combined with some softening of aggregate demand. And part of this disinflation also reflects more competitive conditions that are weighing on firms’ pricing power. 

With economic growth slackening, these trends are likely to continue, allowing the Federal Reserve to start cutting interest rates. So politicians should let the Fed worry about getting inflation down, and if they really want to help, they might think about reining in the federal budget deficit.

In a recent paper with John Roberts, we documented the emergence of a “wage gap” that had emerged since the pandemic.¹ As shown in figure 1, following the pandemic recession in 2020, price inflation, as represented by the change in the Fed’s preferred Personal Consumption Expenditures (PCE) price index, surged well above wage growth, as shown by the Employment Cost Index (ECI). This surge in prices reflected the most standard of market forces: shortfalls in supply triggered by pandemic disruptions combined with increases in demand stemming from President Donald Trump and Biden’s stimulus packages.

As a result, real wages fell below their pre-pandemic trend, shown in figure 2. That trend is upward sloping, reflecting productivity gains over the preceding years. Although productivity growth continued during the years since 2019, it has yet to be fully reflected in wages.

In consequence, as shown in figure 3, a “wage gap” has emerged between real wages and their trend. The counterpart of this widening of the wage gap has been a rise in the markup over costs of the prices firms charge for their products. 

Essentially, by reaping the windfall gains associated with excess demand for goods and services, firms kept for themselves the productivity gains that ordinarily would be paid to workers. In that limited sense, widening profit margins contributed to rising prices during the initial phase of the pandemic inflationary surge.

Subsequently, the restoration of supply conditions and softening of demand led to a fall in inflation, both as commodity costs declined and as more competitive market conditions eroded markups of price over costs. To analyse these impacts, we developed a model that relates core PCE price inflation (excluding food and energy) to past inflation, nominal wage growth, supply-chain pressures (as calculated by the Federal Reserve Bank of New York), and our measure of the wage gap shown in figure 3 above.² We then used the model to decompose the evolution of inflation over the past several years into the contributions of its various driving forces, as shown in table A below.

As shown by the contribution in the second column, the model’s steady-state prediction of inflation – when wage growth equals its trend pace and there are no supply disruptions – is 2%, the Fed’s target. In the third column, wage growth appears to be a primary driver of inflation. 

However, as we document in the paper, most of the rise and fall in wage growth is itself explained by the rise and fall in inflation – wage growth has not been a separate, exogenous driver of inflation. That role appears to belong to supply-chain disruptions, shown in the fourth column, which substantially boosted inflation through 2022 before easing subsequently, leading to a reversal of the inflationary surge.

The fifth column shows the contribution of the wage gap to inflation. Positive wage gaps – when real wages are above their trend level – should lead firms to boost prices in order to recover higher costs. Conversely, negative wage gaps – real wages below their trend level – should lead to lower prices as competitive forces eat away at elevated markups. As shown here, the negative wage gaps documented in figure 3 above are estimated to have subtracted 0.75 percentage points from inflation in 2023 and the first half of 2024.

With wage gaps still sizeable, we expect competitive pressures to continue to weigh on markups for some time to come. Combined with softening economic growth and diminishing wage inflation, this suggests inflation should remain on its downward trajectory. 

This should increase the Fed’s confidence that it can start cutting interest rates, and remove the need – if there ever was one – for presidential candidates to interfere with private price-setting.