The CPI-PPI Gap: More Evidence of a Profit Margin Squeeze

Several weeks ago, I wrote an article titled "Upstream Pressure, Downstream Reality: What the CPI vs. PPI Gap Means for Corporate Profits and the Economy." In that piece, I argued that the growing gap between producer inflation (PPI) and consumer inflation (CPI) suggested that businesses were absorbing a significant portion of rising costs rather than fully passing them on to consumers.

Over the weekend, ZeroHedge published an article by Lance Roberts titled "PPI Vs CPI: Are Record Profit Margins About To Get Squeezed?" that reached a remarkably similar conclusion.

The central thesis of both analyses is straightforward: when producer prices rise faster than consumer prices, businesses face pressure because their input costs increase faster than their selling prices. In other words, someone has to absorb the difference. When consumers are unable or unwilling to pay higher prices, corporate profit margins become the shock absorber.

As Roberts summarizes, “the PPI vs CPI gap says companies are absorbing costs their customers can't afford, and record margins leave very little room to absorb much more."

That is essentially the same conclusion I reached in my earlier article.

What I found particularly valuable in the ZeroHedge analysis was the historical context. Roberts examined prior episodes where producer inflation outpaced consumer inflation by a wide margin and found that “six times since 1950, producer inflation outpaced consumer inflation by 4 points or more. In four of them, the profit share of GDP fell 1 to 4.4 points within two years. The two exceptions had consumers with rising incomes. Today, real hourly earnings are down 0.7%.”

The historical evidence supports a point that I believe is especially important. The PPI-CPI gap alone does not automatically guarantee falling profit margins. The critical question is whether consumers have the financial capacity to absorb higher prices. If incomes are rising sufficiently, businesses can often pass costs through successfully. If incomes are stagnant or falling in real terms, passing through higher prices becomes much more difficult.

This is what makes the current environment noteworthy. We have rising upstream cost pressures, record corporate profitability, and evidence that real wage growth remains weak. If these conditions persist, history suggests that profit margins could come under increasing pressure over the next couple of years.

Conclusion 

I continue to agree with what I view as the article’s most important observation: “Costs can climb for a long time before margins crack. The crack comes when the customer stops paying.”

Time will tell whether businesses ultimately succeed in passing these higher costs on to consumers or whether profit margins absorb a larger share of the adjustment. For now, the PPI-CPI gap remains one of the indicators I am watching closely.