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Theme: Inflationary forces

The dynamic between inflation, real wages and profit margins

High inflation has caused real wages and salaries to fall. In the United States, they are now 5-7 per cent below their historical trend. In Sweden the divergence is even greater. This decline cannot be explained by pandemic-related production disruptions and falling productivity. The main driver is higher world market prices. Profit margins in the business sector have risen, but this increase is mainly visible among energy and commodity producers, which have benefited from high world market prices. Real wages now appear to have started a recovery via a combination of higher nominal pay and lower inflation. Because of divergence from the long-term trend, a reversal of the price increases of recent years is not an unlikely scenario.

High inflation during 2022 and 2023 has led to a sharp decline in real wages. We must go back to the early 1980s to see a similar development. Since the beginning of 2019, real wages have fallen about 6 per cent in Sweden, 4 per cent in the euro area and 2 per cent in the US, where real wages have declined less due to higher nominal wage growth. Compared to the historical trend, however, the drop is a full 5 per cent. The corresponding divergence from trend was a full 9 per cent in Sweden and 6-7 per cent in the euro area during Q1 2023.

Inflation is now slowing down. At the same time, nominal wage growth is accelerating. This means real wages are rising again. Given our forecasts for wages and inflation, normalisation looks likely to take several years. To understand whether an adjustment can occur faster, and if so, how the dynamic may play out, this theme article focuses on what contributed to the decline in real wages.

Strong productivity during the pandemic 

An initial observation is that domestic production disruptions have not driven prices higher, at least not overall. Swedish productivity growth has instead been higher in recent years than the historical trend. This is also true of the US. But in the euro area, productivity growth seems somewhat below trend.

Although Swedish productivity growth has slowed, it has not yet fallen below trend. It is following a normal cyclical pattern. Productivity growth will fall below trend over the next year for cyclical reasons, but there is currently no indication that it has greatly affected inflation and thus the real wage decline of recent years.

Deteriorating terms-of-trade

Because Swedish productivity growth has apparently not weakened, lower real wages may instead have been driven by higher business profits and/or import costs. There are signs suggesting that both these factors have helped fuel higher inflation; for example, import prices in Sweden and the euro area have risen 5-10 per cent more than export prices, weakening terms-of-trade. Due to their dependence on external energy, both have been affected more negatively than, for example, the US.

Higher profits, but unevenly distributed

There are also indications that higher business profits have contributed to lower real wages. For example, the profit margin has risen to the highest levels in many years. But much of this increase is connected to the energy and commodity sectors. These developments vary greatly between industries. 

However, it is hard to measure business profits. Profit margin is a rough measure that tends to diverge significantly from reported earnings. For example, data from the National Institute of Economic Research’s economy tendency survey indicate depressed profits in Sweden’s retail and service sectors, while manufacturing margins have held up fairly well. Relatively high manufacturing profits are probably related to the weak krona and only partly reflect the ability of companies to raise domestic prices. The NIER survey also supports the view that the increase in margins is not driven by a broad upturn in business earnings, especially in domestic sectors. 

Recovery is likely – but uncertain how fast

A real wage recovery is likely in Sweden, the euro area and the US, but there is uncertainty about how fast this will occur. It is also uncertain whether the recovery will take place through rising nominal wages or lower inflation. Developments look the most positive in the US.

To some extent, the adjustment in real wages has already begun. High energy prices ─ a key driver of growing operating surpluses in some sectors ─ and terms-of-trade deterioration in 2022 have been partially reversed. They have thus already helped push down inflation. Large portions of consumer price increases have been reversed. The decline is expected to continue in the coming year. But energy prices remain far higher than in 2019, especially in the euro area. Subsidies, tax cuts and price controls softened the energy price upturn in euro area CPI but help lower inflation now that prices are falling. 

Higher food prices can explain 3.5-4.5 percentage points of the rise in inflation in Sweden and the euro area; the US upturn is marginally smaller. Food price increases have stalled, but there are currently no clear signs that they may soon be reversed. Commodity prices have fallen slightly, but their levels are still very high. Larger declines will probably be necessary for CPI prices to also fall as clearly. High energy prices have most likely contributed to high food prices. In addition, international prices for fertilisers have reversed more than half the 2022 increase.

The upturn in inflation has been broad-based overall, and core inflation has been significantly higher than before the crisis. Besides indirect effects from energy and food, large increases in global commodity prices have been important. As with food, it seems possible that some of the increases can be reversed. For example, global freight rates have given up almost their entire upturn from the aftermath of the pandemic. 

Higher nominal wages – some price declines

The allocation between wages and business profits, i.e. the profit margin, varies over time around a long-term average. It is therefore likely that a relatively large proportion of the real wage declines of recent years will be reversed. Initially, higher nominal wage increases will thus be an important driver. However, inflation has also slowed significantly ─ so far mainly due to lower energy prices and stagnating increases in food prices.

A broader deceleration in inflation is on the way. In the US, core inflation has clearly started to fall. The extent of this decline is uncertain, but there are many indications that goods inflation will be lower than its historical trend soon. This will help push core inflation even below central bank targets for a while. But there is great uncertainty, and our inflation forecast must weigh potentially falling goods prices against accelerating wage increases.

It is unusual for price increases in the CPI to be reversed, but a slight reversal in the large goods price increases of recent years is a downside risk to our CPI forecasts. The large decline in real wages reflects that their potential impact could be significant. If they rise in line with our forecasts, there may be an adjustment in real wages during a long period of low inflation. But such developments presuppose that energy and international commodity prices will not rise again − far from a sure thing in the current uncertain geopolitical environment.