MONETARY POLICY REPORT | AUTUMN 2022 (box 1)
(authors: Ondřej Michálek, Matěj Šarboch, Jan Žáček)
The Czech and European economies have been grappling with dramatically rising energy prices for more than a year now. This growth escalated with Russia’s invasion of Ukraine, and a reduction in gas supplies from Russia has exacerbated the situation. Prices of energy – especially gas and electricity – have reached previously inconceivable levels and are strongly affecting household budgets, corporate performance and government finances. This box examines the financial situation of firms and sole traders and the intensity with which these sectors are passing the rapid growth in their production costs through to end prices. It also tries to answer the question of how businesses’ profits are evolving in relation to their long-term trend, that is, whether producers are raising their profits more than is usual even in an environment of rapid growth in costs.
Businesses can increase their profits in several ways: by cutting costs (which, however, is hard to do in the current highly inflationary environment), by selling more products and services, or by raising their unit price. As the quantity of goods and services demanded by Czech consumers (their real consumption) has not risen over the last three quarters, any growth in profits would evidently be due to sharp price hikes.[1] This would create inflationary pressure, which is undesirable for monetary policy amid the current double-digit inflation.
Price pressures in the economy can be gauged in more detail by decomposing the GDP deflator and the gross value added (GVA) deflator. The GDP deflator (see Chart 1)[2] can be decomposed on the basis of the decomposition of nominal GDP, which in income terms is the sum of gross operating surplus, compensation of employees and net taxes and subsidies. Dividing all the terms in this equation by real GDP gives us the breakdown of the GDP deflator by components. The gross operating surplus per unit of output (unit profit) can be further broken down by sector into households, non-financial corporations and others.
Chart 1 – Compensation of employees, profits of entrepreneurial households (sole traders and entrepreneurs) and net taxes were the biggest contributors to growth in the GDP deflator in the first half of this year
GDP deflator; y-o-y growth in %; contributions in pp
Note: The sum of the contributions of productivity and compensation of employees is roughly equal to the contribution of nominal unit labour costs.
From the recent perspective, the increased contribution of the unit profit of entrepreneurial households (the self-employed – entrepreneurs and sole traders) deserves particular attention. Following the Covid shock, the self-employed have made up for some of their lost profits. This is signalled in the GVA deflator (see Chart 2) by the dominant contributions of trade, including transport and restaurant services, i.e. the sectors that were hit hardest by the pandemic lockdowns and in which small businesses (sole traders and entrepreneurs) are strongly represented.
Chart 2 – The price pressures in the economy are broad-based, being most visible in trade, transport and restaurant services, where small businesses (sole traders and entrepreneurs) are strongly represented
GVA deflator; y-o-y changes in %; contributions in pp
Note: Trade includes hotels, restaurants and transport.
The contributions of unit net taxes – the difference between taxes and subsidies per unit of output – are also significant in the GDP deflator decomposition. This reflects the phasing-out of Covid support programmes. The contributions of compensation of employees – an indicator of labour costs – are also sizeable, although they are generally below the pre-pandemic levels. The unit profit of non-financial corporations (medium-sized and large firms) is roughly inflation-neutral.
The current gross operating surplus (profit) of sole traders is linked with the current double-digit inflation. It was therefore adjusted for price effects using the GDP deflator. Chart 3 shows the trend-cycle decomposition of the adjusted time series. It is evident that sole traders have recently been able to generate higher real profits than the trend level would imply. This signals higher-than-usual real profits, which are probably the result of rising product prices against the backdrop of (until recently) solid household demand for the goods and services produced by the business sector. Had consumers been unwilling to accept high prices, businesses would conversely have had to reduce their profits.
Chart 3 – Sole proprietors’ profits are currently above the trend level
households’ gross operating surplus in CZK billions; constant prices; HP filter (lambda = 1,600)
In terms of profit volumes, non-financial corporations are the most important sector for the Czech economy, generating more than half of its earnings. The trend-cycle decomposition of their real gross operating surplus, presented in Chart 4, shows that the volatility of profit generation after the pandemic has been within the usual range seen in recent years. To obtain a more detailed sectoral breakdown, we used granular data on around 2,000 of the largest domestic companies.[3] Owing to the high volatility of the data, however, the trend-cycle decomposition gave no clear answer. In Chart 5, therefore, we describe the economic condition of firms using the profit rate, defined as the ratio of profit to book value added. In all sectors, the profit rate is at least equal to the pre-pandemic level. The highest rate was recorded by telecommunications. However, the situation in this sector is significantly distorted by the latest observations in one large telecoms corporation. Profitability in the mining and energy sector is also high. This is probably linked with the rise in energy prices over the last 12 months. Manufacturing, which has been hit by problems in global value chains since the pandemic and by the current energy shock, is maintaining a solid profit rate. The profit rates in other important sectors of the domestic economy – trade, transport and restaurant services – are increasing.[4]
Chart 4 – Except for a sharp drop during the pandemic, corporate profits have stayed close to the trend
non-financial corporations’ gross operating surplus in CZK billions; constant prices; HP filter (lambda = 1,600)
Chart 5 – The profit rate of large firms is solid across sectors
profit rate in %; annual moving average
Note: Trade includes hotels, restaurants and transport.
The hypothesis that firms are in solid condition as a result of higher mark-ups is supported by the estimate of the gap in mark-ups in the consumer sector in the g3+ core forecasting model. Mark-ups in the consumer sector are the difference between observed prices and the estimated marginal unit costs of producers of final consumer goods. The gap in mark-ups shows the deviation of current mark-ups from their steady-state level. A positive gap in mark-ups thus implies a higher-than-usual “profit margin” and a negative gap a lower-than-usual one. If the gap increases (decreases) over time, it gives rise to an additional inflationary (anti-inflationary) effect, i.e. upward (downward) pressure on consumer prices going beyond the increase (decrease) in costs. As Chart 6 shows, the slightly negative gap in mark-ups started to close at the start of last year and turned positive last autumn. The gradual growth of the gap in mark-ups reflected the gradual retreat of the pandemic and persisting strong consumer appetite, reflecting the realisation of deferred demand and spending of forced savings. In addition, the post-Covid demand for goods and services, amid still disrupted global value chains, caused demand to considerably exceed supply, opening up space for growth in producers’ and retailers’ margins.
Chart 6 – The gap in mark-ups in the consumer sector has turned highly positive in the last year
gap in mark-ups on consumer goods in %; CNB calculations
[1] Overall demand for firms’ and entrepreneurs’ production does not consist only of household consumption, but largely also of the other expenditure components of GDP, such as exports. However, we focus primarily on the demand situation in the domestic environment, for which household consumption is the most suitable proxy.
[2] The presented decomposition of the GDP deflator is based on the Lithuanian central bank’s Analysis of profit indicators calculated from national accounts, Lithuanian Economic Review, December 2015. This paper contains a very detailed and readable description of the calculation methodology. In addition to this source, we drew on Economic and Monetary Developments, Autumn 2022, Box 2, National Bank of Slovakia. In preparing this text, we were also inspired by three analytical boxes published by the ECB: How do profits shape domestic price pressures in the euro area?, ECB Economic Bulletin, Issue 6/2019, What accounts for the recent decoupling between the euro area GDP deflator and the HICP excluding energy and food?, ECB Economic Bulletin, Issue 6/2016, and Using national accounts data to gauge price pressures in the euro area, ECB Monthly Bulletin, December 2006.
[3] The data are taken from respondents’ answers in the CZSO P6-04 questionnaire covering the largest companies by asset size.
[4] The profit rate of non-financial corporations according to the CZSO’s aggregate data (i.e. including small and medium-sized enterprises) reached 44.7% in 2022 Q2. It was thus the same as in the previous quarter but 2 percentage points lower than a year earlier.