The role of profit margins in the adjustment to the COVID-19 shock

Prepared by Elke Hahn

Published as part of the ECB Economic Bulletin, Issue 2/2021.

Profit margins are an integral part of domestic price setting and have had an impact on the response of euro area inflation to the coronavirus (COVID-19) shock. Growth in the GDP deflator remained robust in the first half of 2020, despite the sharp fall in economic activity. This box illustrates that developments in profit margins in terms of unit profits (i.e. gross operating surplus per unit of GDP) have been exceptional during the crisis, including in comparison to past recessions, and have shaped GDP deflator-based inflation developments. The box also elaborates on likely sources of the unusual profit margin response and examines developments in more granular profit indicators in main institutional sectors since the start of the crisis.

Developments in the GDP deflator and its components have been exceptional since the start of the COVID-19 crisis (Chart A). Despite the recession, the annual growth rate of the GDP deflator rose to 2.3% in the second quarter of 2020, from 1.8% in the first quarter, before slumping to rates around 1.0% in the following two quarters. This was the largest movement between two quarters in the history of the series. However, rather than reflecting genuine changes in domestic price pressures, the hump in the profile of the GDP deflator appears to reflect mainly statistical measurement effects.^[1] At the same time, changes in the components of the GDP deflator also went far beyond those observed in past crises. In particular, unit labour costs posted a sharp temporary increase in the second quarter, and unit taxes less subsidies on production made an unprecedentedly large negative contribution to the GDP deflator. The latter reflected government support measures implemented in the context of job retention schemes, while in the third and fourth quarters lower recourse to these schemes in view of the rebound in economic activity led to a significant decline in this contribution.^[2] Job retention schemes also had a substantial impact on developments in profit margins during the crisis, as discussed below.^[3]

Total profits declined sharply during the COVID-19 crisis in both the non-financial corporation (NFC) sector and the household sector (Chart B). Both the gross operating surplus of NFCs and the gross mixed income of the smaller unincorporated enterprises covered by the household sector, which together account for roughly three quarters of total economy profits, dropped significantly in the second quarter of 2020 and much more strongly than during the great financial crisis.^[4] In the third quarter of 2020 much of the decline in profits in the previous quarter was recouped. The same was true for most of the more specific profit indicators available for the NFC sector. Only net retained earnings, which have developed relatively favourably in recent years, remained at a more modest level.

Despite the overall fall in profits, unit profits have shown resilience relative to the depth of the recession. Developments in unit profits are highly cyclical and tend to strongly co-move with cyclical indicators like GDP and labour productivity (Chart C). However, in the second quarter of 2020 the typical cyclical co-movement of unit profits with real economic activity broke down. This can be clearly seen when a comparison is made with developments during and after the great financial crisis. In the second quarter of 2020 unit profits were weak, but held up much better than implied by typical cyclical co-movement, even providing a small positive contribution to the GDP deflator, despite the strong fall in GDP. In the third and fourth quarters of 2020 unit profits remained weak and disconnected from the sharp cyclical rebound, but were still stronger than implied by the cyclical situation as reflected in, for instance, developments in GDP. While statistical measurement effects are likely to have played a role in developments in unit profits, they cannot explain their observed resilience.

Empirical evidence based on past recessions points to non-linearities and relatively more moderate cyclical adjustments of unit profits during recessions than during expansions (Chart D).^[5] The results from a threshold vector autoregressive model indicate that a demand shock has a proportionally smaller effect on inflation in recessions than in expansions on account of a smaller response in unit profits, and this behaviour also appears to have prevailed during the COVID-19 crisis.^[6] The estimated non-linearity in the response of unit profits also helps to explain why inflation tended to fall by less in past recessions than signalled by linear models, a behaviour referred to as “missing disinflation”. Nonetheless, the resilience of profit margins during the COVID-19 crisis is exceptional, even when compared with past recessions.

Job retention schemes have played an important role in the resilience of unit profits during the COVID-19 crisis.^[7] In the early stages of a downturn firms generally strive to retain workers, even at the cost of lower profit margins. This downward pressure on profit margins can be alleviated by government wage support schemes. Such schemes have been much more common during the COVID-19 crisis than during previous recessions, and this probably explains the resilience of profit margins in the current crisis when compared to past recessions.

To conclude, while profits have fallen more strongly during the COVID-19 crisis than during earlier recessions, relative to activity they have shown a high degree of resilience. This has contributed to the attenuation of downward pressures on inflation during this period. It is likely that the strong resilience of profit margins during this crisis reflects both the normal resilience of profit margins in recessions and the impact of job retention schemes. As job retention schemes are likely to remain in force as long as the COVID-19 crisis persists, profit margins may be expected to remain relatively resilient given the activity developments.