Euroland: Gauging Margin Pressure
Elga Bartsch (London)
Crude oil prices are on the rise. Despite the fact that other commodity prices have started to ease a little recently, this has given rise to concerns about the sustainability of the recovery. The risks to the recovery stemming from surging oil prices are twofold. First (and foremost I would add), is the consumer cycle where the negative impact on real disposable income available for discretionary spending is well documented (see Eric Chaney and Annamaria Grimaldi, Who Paid for the Oil Shock?, July 2, 2001). Second, oil prices are seen impacting profits, and even more so profit margins. This is one, but probably not the most important factor responsible for the negative effect of higher oil prices on investment spending.
In the following we analyse recent trends in the euro area profit margins and try to assess the impact of rising oil prices on margins by looking at different profit measures. Interestingly, we find that the impact of oil price gyrations on the price-cost ratio, our rough and ready gauge of macroeconomic profit margins based on a comparison of the GDP deflator and the unit labour costs, has been very limited in the past. This somewhat surprising result is in line with the fact that labour costs account for by far the largest chunk in corporate costs. Likewise, we did not find oil prices to be a significant factor in determining quarterly changes in the gross operating surplus, the macro economic equivalent of EBITDA. This suggests that the negative impact of an oil price shock on investment spending comes largely through the negative impact on consumer demand, not from an impact on profitability. In addition, higher uncertainty about the economic outlook might play a role in holding back investment spending.
That said, in the industrial sector there are some signs of margin pressure. Take for instance the producer price index: In the absence of official data on a core PPI, we have constructed a simple measure by stripping out intermediate and energy components from headline PPI inflation. Comparing this measure of ‘factory gate’ inflation to headline inflation would indicate noticeable margin pressure in the industrial sector. These pressures become even more visible when comparing factory gate (also known as producer output price) inflation to input price inflation for April, the latest available data. The extent of margin pressure can be grasped by comparing headline PPI inflation to the core rate. Whenever the former is running above core inflation manufacturing, margins get squeezed because, by definition, input price inflation is higher than output price inflation. Furthermore, information from the Purchasing Managers’ survey for May suggests that this pressure has increased further. Comparing recent trends in the PMI prices paid series with actual producer prices echoes the message of margin pressures. Estimate of PPI inflation based on the PMI prices paid series shows that so far Euroland industrialists have only managed to pass on a fraction of the higher input prices to their customers. While we expect PPI inflation to pick up noticeably in the coming months, we don’t foresee a rise to more than 5%, the level that would be consistent with recent PMI readings.
Taking more of a bird’s eye perspective, it seems that some important changes occurred in the euro area price cost ratio in the last few years. Contrary to the 1990s, the price-cost ratio no longer seems to exhibit a discernable cyclical pattern such as the one observed during the 1990s. The collapse in the cyclical pattern is likely related to the arrival of the euro, we think. Despite the external value of the euro hitting record lows at this time, this has not helped euro area companies to improve their profit margins. Interestingly, we find no meaningful impact of EUR on profit margins -- not even in the export sector. Other factors causing the cyclical pattern to vanish include structural shifts in the euro area labour market and their temporary negative impact on labour productivity. More recently, however, the correlation with real GDP growth seems to be re-establishing itself.
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Euroland: Third Time Lucky
Joachim Fels and Elga Bartsch (London)
Entrusted with the task of preserving price stability, the ECB never tires of emphasizing the importance of anchoring inflation expectations at low levels. With both market-based and survey-based indicators of inflation expectations on the rise, it thus hardly comes as a surprise that ECB President Trichet voiced concerns about potential upside risks to price stability and called for “vigilance” at yesterday’s press conference. In our view, the ECB is even more worried about the unfolding of an inflationary scenario than the President dared to admit. Thus, if inflation expectations remain at elevated levels during the summer, the ECB could start to raise rates earlier than generally expected. However, there still is a good chance that the ECB turns out to be ‘third time lucky’ in the sense that, as in the summer of 2002 and in the autumn of 2003, external events conspire to push inflation expectations back down again and remove the need for an early tightening move. On balance, we therefore stick to our long-held view that the ECB will only start to ‘normalise’ policy towards the end of this year.
With headline consumer price inflation having surged to 2.5%Y in May, it looks increasingly likely that, for the fifth consecutive year, inflation in 2004 will remain above the upper limit of 2% that the ECB deems compatible with price stability. Annual inflation has averaged between 2.1% and 2.3% in the years 2000-2003, and the Eurosystem staff’s freshly published macro projections now call for it to average 2.1% this year, up from the 1.8% staff projection made last December. Even though the ECB, like most other forecasters, has consistently under-predicted inflation for many years now, this in itself does not appear to overly worry the ECB Council as long as inflation is expected to fall back into the ‘stability zone’ over the medium term. In fact, as in all the previous years, the ECB again projects inflation to average less than 2% (1.7% to be precise, revised up slightly from 1.6%) next year on its main scenario. The Council’s central case thus is, so far, that the run-up in headline inflation caused by surging oil prices and major increases in indirect taxes and administered prices will not lead to second-round effects on inflation next year.
But herein lies the catch. Most measures of inflation expectations have increased along with actual inflation recently. First, bond market inflation expectations, as measured by the gap between nominal yields and real yields on inflation-protected bonds, have surged to their highest level since the start of EMU across maturities. While these so-called break-even inflation rates are an imperfect gauge of true inflation expectations, their sharp rise “calls for particular vigilance,” to quote from the ECB President’s statement yesterday. Second, following a drop to record lows in April, euro area private households’ price expectations have rebounded in May, according to the EU Commission’s latest monthly consumer survey. Similarly, business surveys show a rise in price expectations across the board. And third, professional forecasters, including the ECB’s own staff, have started to nudge up not only their estimates of 2004 inflation but also their forecasts for 2005. It is these developments in expectations, rather than the recent increase in actual inflation, that are causing the headache for the ECB. The longer inflation expectations rise or remain at elevated levels, the bigger is the risk that wage growth picks up and higher inflation becomes engrained. Note that this is exactly what happened after the 1999/2000 surge in oil prices and headline inflation, despite a series of ECB rate hikes during that period.
However, while the ECB is now in a state of heightened “vigilance” with respect to inflation expectations, the Council is still unlikely to jump to interest rate conclusions for the time being. After all, the rise in inflation expectations may still turn out to be short-lived, as it did twice before. The first such episode occurred in the spring of 2002, when signs of economic recovery and stubbornly high inflation conspired to push up market-based inflation expectations and induced the ECB to shift to an informal tightening bias. Yet, a vertiginous drop in equity markets and a fizzling of the nascent recovery during the summer of 2002 quickly pushed inflation expectations back down and relaxed the minds at the ECB. The second episode played out last autumn, when market-based inflation expectations again surged and the ECB started to get worried. Then, the sharp rally in the euro between November and February changed the picture and pushed break-even inflation rates lower again. It is, of course, difficult to say what kind of external event could do the trick this time round, but a prime candidate has to be a sharp drop in oil prices, perhaps in response to a combination of increased oil supply and a hard landing in China. In this case, inflation expectations would likely ease and the case for an early ECB tightening would dissipate. However, we remain reluctant to assume that the ECB will be ‘third time lucky’ and will get away without a rate hike this year |
