As strange as this might sound, the actual economic cost of inflation is often hard to identify. One might think that it’s obvious that if inflation rises from 0% to 5% then the purchasing power of “real” incomes (nominal incomes adjusted for inflation) throughout the economy has fallen by 5%.

But that’s not right—or at least it’s not right without some further specification about just whose income has fallen. The “circular flow” diagram that is in chapter one of most macroeconomic textbooks highlights something profound: one person’s cost is another person’s income. So, when the price of eggs rises by 30%, that extra money out of shoppers’ pockets doesn’t disappear into thin air, instead it lands someplace. In the case of eggs, that someplace could be in chicken farmers’ incomes, or the profits of middle-men brokers, or the profits of grocery stores.

There are times when inflation really can be driven by most incomes in society rising at mostly the same pace. In this case, inflation is distributionally neutral, but there’s also no “real” cost. For example, if inflation accelerates from 0% to 4%, but nominal wage growth accelerates from 2% to 6%, real wages haven’t been harmed. The inflation we’ve seen since 2021 has had profound distributional consequences. Prices and incomes for low-wage workers, middle-wage workers, high-wage workers, and profits have not moved in lockstep but have seen very different rates of growth.

Most striking is the role of profits in starting and sustaining inflation since 2021. Figure A below shows one measure of profit “mark-ups” in the non-financial corporate (NFC) sector of the U.S. economy. We look at this sector because it has rich and timely data coverage. Mark-ups are essentially profits earned per unit of output divided by labor and non-labor costs.

When these profit markups rise, the result is increasing prices for consumers (inflation). The very large spike in the beginning quarters of the COVID-19 recovery is clear. Since then, mark-ups have come down a little, but remain extremely elevated relative to historic norms. Many (including me) had hoped these high mark-ups would relent sooner and provide more relief from too-high inflation by now, but it has not yet happened in a serious way.

Figure B shows the contribution of profits, labor costs, and nonlabor costs to growth in NFC prices since the COVID-19 recovery began (in the second quarter of 2020). Measuring since the last business cycle peak (the fourth quarter of 2019) does not change this story radically.

In normal times, corporate profits contribute about 13% to prices. Since the second quarter of 2020, they have instead contributed more than a third of price growth, or more than twice as much as they normally do. This contribution was larger in previous quarters, which means the slight decline in mark-ups shown in Figure A has put a small bit of downward pressure on inflation in recent quarters. But there remains a long way to go before profits are back to normal.  

What the extreme profit bias of recent inflation means for economic policymakers is relatively complex. We provide some overview of these issues here. The most important takeaway is that measures aimed at dousing any presumed inflationary overheating in the labor market are absolutely not addressing the key drivers of inflation.