inflation: how ‘Excuse inflation’ keeps prices and corporate profits high

“Whether it’s rye flour or the avian flu hitting eggs,” says Ken Jarosch, the owner of Jarosch Bakery, “when it makes national news, just running a business is an opportunity to raise prices without a whole lot of complaining to get.” of the customers.”

It’s not something you usually hear a business owner utter in public, but Jarosch just put forth his philosophy late last year about when it’s safe for a company like his — a medium-sized bakery in Chicago’s suburbs — to raise cookie prices. , increase pies. and other carbohydrates. He had the idea long before Covid turned supply chains upside down, and realized he could quickly implement price increases if news of a major shock to the economy came, as there will be less backlash from customers at that point.

Now a growing number of analysts and researchers are seeing this pattern playing out in corporate America, with companies using unusual disruptions as an excuse to raise prices for their goods and services, helping them to increase their profit margins.

And over the past few years, companies have been able to point to a medley of “once-in-a-lifetime” emergencies resulting from the pandemic and the Russian invasion of Ukraine, which have combined to upend everything from the production of semiconductors to commodity markets and shipping.

The key question is, in an economy where consumers continue to spend freely, how sticky this “excuse inflation” turns out to be, and how high the Federal Reserve will have to raise interest rates to induce companies to lower, or at least increase, their prices. stop raising interest rates. them. At 6.4%, annual inflation is below last year’s high, but still well above the Fed’s target of 2%.

“A lot of companies had these one-off or very, very rare excuses to raise prices and start to figure out how much the consumer would take,” said Samuel Rines, a general manager at Corbu LLC, in the latest episode of the Odd Lots podcast. “Once you get that pricing pressure, once you figure out that the consumer is willing to pay for it, that’s an expansive margin over time as you start to get a normalization of your input costs.”

He cites a plethora of companies taking price over volume, or the “POV” strategy, as he calls it. These include all-American favorites like PepsiCo Inc. and Home Depot Inc. and even two retailers long known for their discounted prices: Walmart Inc. and Dollar Tree Inc. a major blow to market share, in this environment of less than 3.5% unemployment and average hourly wage growth of more than 4% per year, consumers largely swallow these price increases. They have typically delivered only modest hits to customer demand. That explains why the Fed is so focused on cooling down the labor market – and wage growth in particular – to bring inflation back under control.

In the meantime, a determinant of this excuse inflation — and one possible reason why it’s proving difficult to eradicate — is that it gives companies a cover to raise prices together, undermining customers’ ability to vote with their feet by shopping elsewhere. shopping is limited.

Pepsi pricing power
“We call it the new PPP,” says Rines, short for “Pepsi Pricing Power.”

It actually enabled the soft drink giant to raise prices, he says, to make up for volume losses in Russia following the invasion of Ukraine. This is very different from the conventional narrative that the war was inflationary because it upended major commodity markets, especially oil, gas and wheat.

As Rines sees it, Pepsico consumers around the world began paying more to compensate Pepsico investors for the loss of the Russian consumer market. And while traditional economics would argue that consumers should eventually switch to cheaper alternatives or the Coca-Cola Co., that hasn’t really been the case until now.

“You shouldn’t theoretically allow Pepsi to drive up the price, right? It should be Pepsi and Coca-Cola battling it out and you have very minimal price increases and they don’t have the ability to really catch up with inflation,” says Rines. “And that’s just not the case right now.”

When asked on a recent call to analysts whether Pepsi would consider reversing price hikes if demand weakens, CEO Ramon Laguarta argued that the company was “trying to create brands that can deliver higher value to consumers and that consumers are willing pay more for our brands”. .”

So not really. (Pepsi did not respond to a request for comment).

Once companies enter higher prices, there isn’t much incentive to reverse them.

The result is an increase in profit margins at both Pepsi and Coca-Cola – and large companies in general.

It’s a point picked up by UMass Amherst economists (and frequent Odd Lots guest) Isabella Weber and Evan Wasner. They cite an explosion in corporate profit margins to a record 13.5% in the second quarter of 2021 as evidence that companies are moving beyond simply passing on higher input costs to customers.

In new research published last week, they dubbed the phenomenon “seller inflation,” noting that a series of “overlapping emergencies” in recent years had effectively given companies the linkage they needed to collectively raise prices.

“Bottlenecks can create a temporary monopoly power that can even make it safe to raise prices, not only to protect profits but also to increase profits,” says Weber. “This implies that market power is not constant, but can change dynamically in a changing supply environment. Publicly reported supply chain bottlenecks and cost shocks can also serve to create legitimacy for price increases and create consumer acceptance to pay higher prices, making demand less elastic.”

Because these disruptions and shocks have often affected entire industries, companies can raise prices without fear of losing market share, even to two notorious competitors like Pepsi and Coca-Cola.

“Companies are not lowering prices because this could spark a price war,” Weber writes. “Companies compete for market share, but if they lower their prices to gain ground against other companies, they should expect their competitors to respond by lowering their prices in turn. This could result in a race to the bottom that destroys industry profitability.” That means there’s little incentive to roll them back once they’re done.

“If these cost increases are not unique to individual companies, but are experienced by all competitors, companies can safely increase their prices because they have a mutual expectation that all market players will do the same,” she notes.

Wings don’t stop
Rines likes to talk about a chicken wing restaurant chain called Wingstop as an example of business actions helping inflation take off.

When the wholesale cost of wings skyrocketed in 2021 – it was up 125% over a 12 month period – Wingstop “started pushing the price, pushing the price, pushing the price and they didn’t have any consumer pushback”, he says. “The consumer just kept buying chicken wings and it’s not like there are only a limited number of places where you can buy a spicy chicken wing.”

When wholesale wing prices started to fall from their recent peak, Wingstop didn’t bounce back. Costs are down about 50%, says Rines, but “Wingstop isn’t exactly stopping their price hike. In fact, they say and steer towards a typical 2% to 3% price increase. (Wingstop did not respond to a request for comment.)

The chain’s profit margins are up and its stock is up nearly 250% from the lows it reached during the lows of the Covid-induced market crisis in early 2020.

“Yes, during the year we took the prize. We have another opportunity before us where we’re actively working with our franchisees and they’ll put in somewhere between 4 and 5 points of additional price hopefully during this quarter certainly over the next few months that will culminate in an overall target overall 10% increase, which we think is in line with where inflation is and also in line with consumer demand. So, like other brands, we’re making sure to take our price in this environment to offset some of the near-term headwinds.
– Charlie Morrison, former Chairman and Chief Executive Officer, Wingstop Q3 2021 conference call.

The discrepancy between falling wholesale prices and stubborn retail prices may help explain why inflation has proven so difficult to eradicate, even as many of the one-off shocks — such as the pandemic fiscal stimulus or the initial commodity effect of war — fade into the past. It also poses a challenge to economists who might assume margins would disappear under competitive pressure.

“Most economists have viewed the return of inflation from the perspective of the dominant interpretations of the 1970s: inflation stems from macrodynamics, with the (new) Keynesian interpretation on the one hand posing a question of excess aggregate demand relative to capacity, and the classic monetarist postulation of too much money chasing too few goods on the other side,” writes Weber. “To the extent that cost is considered a role from both perspectives, it is purely a question of over-wage.”

There are some signs that policymakers are beginning to pay more attention to corporate behavior as a driver of pricing, with Lael Brainard, the former Fed Vice Chairman who now heads President Joe Biden’s National Economic Council, arguing in January that: “Retail markups in a number of sectors have led to significant increases in what can be described as a price-price spiral, with final prices increasing more than input price increases.”

And while higher profit margins on the surface may seem like a benefit to investors, when any company is able to raise prices, that’s the behavior that keeps pushing members of the Fed’s Federal Open Market Committee to raise interest rates. feed. , a lid on stock prices.

It’s going to be hard for policymakers to stop raising rates “until they really start to see companies start slowing down prices,” Rines says. “And if Smuckers says it’s 8% for 2023, that’s not good for the FOMC. If Cracker Barrel says wages are going up 5% to 6%, that’s not good for the FOMC. You know, one is a consumer good and the other is Central America getting a raise. If Walmart raises their minimum wage, that’s a pretty big deal when it comes to consumption at the lower end.

“It will be easy” to be fooled by CPI prints pointing to lower inflation in the coming months, says Rines, “and then suddenly get a little caught off guard as companies continue to push up their prices, in an effort to have elasticity on their margin.”

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