When inflation is high, businesses may raise prices to keep pace. However, market watchers and journalists have questioned whether companies have taken advantage of high inflation to boost profits. We look at this question through the lens of public companies, finding that in general, increased prices in an industry are often associated with increased corporate profits. However, the current relationship between inflation and earnings growth is not unusual in the historical context.
Map inflation to public company earnings
We use the producer price index (PPI) published in the North American Three-Digit Industry Classification System (NAICS) and compare industry-level inflation to aggregate earnings of public enterprises in the same industries. We do this for 36 industries, ranging from oil and gas extraction (NAICS 211) to telecommunications (NAICS 517). We do not cover all industries as we limit the analysis to industries with more than 15 public companies, so that the results are not too influenced by a single company.
|NAICS industry codes|
|211 Oil and gas extraction||337 Manufacture of furniture and related products.|
|212 Mining, except oil and gas||339 Miscellaneous manufacturing|
|213 Support activities for mining||423 Durable Goods Merchant Wholesalers|
|221 Utilities||424 Non-durable goods merchant wholesalers|
|311 Food manufacturing||441 Motor vehicle and parts dealers|
|312 Manufacture of beverages and tobacco products.||448 Clothing and clothing accessories stores|
|315 Manufacture of clothing||452 general merchandise stores|
|321 Manufacture of wood products||454 non-store retailers|
|322 Papermaking||481 Air transport|
|324 Manufacture of petroleum and coal products.||483 Water transport|
|325 Manufacture of chemical products||484 Transport by truck|
|326 Manufacture of plastic and rubber products.||488 Transportation support activities|
|331 Primary metal processing||511 Publishing industries, except Internet|
|332 Manufacture of metal products.||515 Broadcasting, except Internet|
|333 Manufacture of machinery||517 Telecommunications|
|334 Manufacture of computer and electronic products.||523 Securities, commodity contracts, investments|
|335 Electr. and appliance manufacturer.||524 Insurers and related activities|
|336 Manufacture of transport equipment.||721 Accommodation|
Many factors affect sales and profits, and determining who benefits from high inflation is a difficult question. The researchers also took these factors into account when analyzing the aggregated data, although it has been difficult to conclusively isolate the extent to which higher inflation comes from increased profits. This is because net sales reflect both the price, quantity and range of goods, which means that increases in sales or profits could be due to higher prices, but also to more goods sold or to changes in the range of goods.
To understand the relationship between inflation and profits, one would ideally be able to break down the number of units sold (not to mention the quality of units sold and the profit margin per unit). Although difficult to do with publicly available data, a simple measure of profitability is gross margin. Gross margin is the difference between net sales and direct cost of goods sold (COGS) normalized by net sales. It captures the difference between the cost of inputs and the revenue of the business. Normalizing by sales to look at gross margin as a percentage, rather than gross margin in dollars, alleviates concerns about misattribution of gross margin dollar growth that comes from selling more goods.
Gross profits increased more for industries with more inflation
The graph below plots the evolution of gross margin and inflation for the first quarter of 2022 compared to the first quarter of 2021. The slope is 0.24, which suggests that on average, for each increase in 1% of prices, corporate gross margins increased by 24 basis points. .
Change in gross profit margin and PPI
Some of the industries with the biggest shifts in profit margins include oil and gas, and industries such as airlines that are heavily impacted by COVID-related shifts in demand. To allay fears that these industries are distorting the observed pattern, we remove them from the chart and find that the upward slope remains. It seems that industries with higher inflation do indeed earn higher profits.
Change in gross profit margin and PPI, excluding oil and gas and COVID-affected industries
Is this time different?
Has the evolution of market power increased the ability of firms to raise prices? We examine the relationship between profit margins and inflation over the past two decades (for which we have inflation data for most industries) as well as over the past four decades (for which we have inflation data for a smaller set of industries). We regress inflation on changes in gross margins based on quarterly data, including the fixed effects of changes in markups over time and for industries on average.
Looking only at how the most recent period compares to historical data, the relationship between inflation and gross profits looks significantly higher in 2021 and the first quarter of 2022. We estimate a positive and statistically significant coefficient on an interaction between inflation and the 2021-22 observations and find that the slope is about 0.36 over this period, compared to 0.29 between 2004 and 2020. However, closer examination reveals that the relationship between profits and inflation is not linear, i.e. when we estimate the relationship separately for different quartiles of inflation, we see that the relationship between inflation and profits changes with the level of inflation. The steepest slope is estimated when inflation is high, but not too high (between 37 basis points and 4.3%, which represents the 25e and 75e inflation percentiles).
This is illustrated in the graph below which estimates the slope of the relationship between gross profit and PPI across all industries for each quarter since 2004 using the full sample, controlling for time and location fixed effects. ‘industry. In the period following the start of the pandemic, the slope has been particularly steep, although it has returned to close to the historical average more recently. Across the entire sample, the slope was greater than 0 almost every quarter with an average of 0.25, indicating a consistent positive correlation between inflation at the industry level and changes gross margins.
The relationship between PPI and gross margin over time
Although we only have inflation figures for a more limited number of industries, the results are very similar when estimated over a longer time series dating back to 1986. The recent relationship between inflation and earnings seems similar to that achieved in the past when inflation was very high. high, as it is today.
This non-linear relationship between earnings and inflation appears in several dimensions in addition to earnings and was initially noted in the work of researchers at the New York Fed (friendship, Heise, and Karahan). This is consistent with theories of strategic complementarities in pricing, according to which knowing that competitors are changing prices encourages firms to change their own prices. Our analysis does not take into account why companies change prices – we only look at inflation in the company’s industry, not input price changes.
Inflation may not be so important to corporate earnings
The relationship between changes in corporate profits and inflation is positive even when inflation is abnormally high. It only means that industries with higher inflation are able to increase their profits more than industries with lower inflation, not that profits increase. Returning to the original chart of profit changes in 2022, the change in gross profits in most industries (22 out of 36) is negative. Overall, profits are falling, and it’s just that companies in high inflation sectors have profits that are falling less rapidly. In addition, gross margin misses many key elements of profit, including selling, general and administrative (SG&A) expenses. To the extent that these other costs change, the overall net profitability of companies may also change. Finally, changes in gross margin are negatively correlated serially, which means that decreases in profits are often followed by increases in profits. This means that profit increases may not be followed by further profit increases.
Mathias Andler is a macro-financial research analyst in the Research and Statistics Group at the Federal Reserve Bank of New York.
Anna Kovner is the Director of Financial Stability Policy Research in the Bank’s Research and Statistics Group.
How to cite this article:
Mathias Andler and Anna Kovner, “Do Corporate Profits Rise When Inflation Rises?”, Federal Reserve Bank of New York Economy of Liberty StreetJuly 13, 2022, https://libertystreeteconomics.newyorkfed.org/2022/07/do-corporate-profits-increase-when-inflation-increases/.
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.