It has been a hot topic in an election year.
- “I will go after the bad actors. (Applause.) And I will work to pass the first-ever federal ban on prou- — price gauging [gouging] on food. (Applause.)” – White House Transcript of remarks by the Vice President (August 16, 2024)
- “We, the Attorneys General of New York, California, Connecticut, Delaware, the District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Michigan, Oregon, New Jersey, New Mexico, Pennsylvania, and Vermont write in support of proposals for a federal prohibition on price gouging.” – a petition from to Congress (October 30, 2024)
- “George Milton, who runs a hot sauce business in Austin, Texas, said consumers are frustrated because it isn’t clear to them why many food prices are so high. ‘Is it price gouging or costs going up for distributors or retailers or farmers? I have no idea,’ he said. ‘Nobody does.’” – The Wall Street Journal (November 2, 2024)
After decades of quiescence, inflation surged in 2021 and 2022. The annualized Consumer Price Index (CPI) increased from about 1.5% to over 9%. The CPI has cooled off since, but prices today are 21% higher overall than before the pandemic.
What caused this painful deviation from stable prices and happy times? Economists have various theories, but one explanation that plays well to the general audience is the idea that “greedy corporations” have engaged in “price gouging” – raising their prices faster than their costs were increasing, or keeping their prices high even as costs come down – squeezing the consumer in a “frenzy of profiteering.”
Diagnosing and controlling abusive pricing is a challenge for economic regulators. Most states have passed some sort of anti-price-gouging law, but these are rarely invoked because price gouging is said to be difficult to prove. The issue assumed greater urgency, however, during the Covid pandemic with its many shortages and associated price spikes. As inflation flared, concern grew about possible corporate misbehavior as a causal factor. The media began to agitate for a response. In 2022, New York published a Notice of Proposed Rule-Making to strengthen existing laws in response to consumer complaints during the pandemic. In February 2024, nine U.S. senators proposed a new federal measure described as the “Price Gouging Prevention Act of 2024.” In October 2024, New York Attorney General Letitia James led the aforementioned coalition of 15 state attorneys general urging Congressional leaders to support a federal ban.
Is price gouging a reality? And if so, is it a “root cause” of inflation?
Most economists dismiss this notion in favor of other theories. But “greed” is often easier for the public to understand than M2 growth (monetary policy), “helicopter money” (excessive fiscal stimulus), or strong labor markets warping the Philips Curve (the supposed trade-off between inflation and unemployment). The idea has gained traction with a few academics and even some officials of the Federal Reserve. Last year Lael Brainard (then vice-chairman of the Fed) brushed aside the “wage-price spiral” (another traditional theory of inflation) and spoke instead of “a price–price spiral, whereby final prices have risen by more than the increases in input prices.”
How could one detect this supposed economic crime?
Higher prices alone don’t prove the case. They may simply reflect higher costs of production.
Higher corporate profits alone don’t prove the case. They could be the result of higher sales volume.
The true indicator is this:
- If a company raises its prices faster than its costs are increasing, its profit margin will expand.
Margins measure how much of each sales dollar ends up on the company’s bottom line. Of course margins may also improve for other reasons — better products, more efficient production methods, lower taxes, or an expanding customer base bringing economies of scale – all ways in a company’s costs might decrease, and margins grow, which wouldn’t necessarily cause inflation.
But if a company’s profit margin increases significantly while prices are going up and overall inflation is accelerating, it could be evidence for price gouging behavior, with inflationary implications.
This concept is recognized in the proposal from the attorneys general cited above.
- “Price gouging prohibitions let businesses raise prices to cover costs—just not raise prices to increase their profits. This is an important difference, because without the ability to raise prices to cover higher costs, businesses would be discouraged from selling essential products (or from increasing supply to meet higher demand) during crises because they would be doing so at a loss. Existing state prohibitions on price gouging address this issue, allow companies to pass on higher costs and maintain profit margins.” [Emphasis added]
Thus, the key is to be found neither in rising prices per se, nor increasing profits per se, but in whether margins are expanding while prices are rising.
So, with this metric in mind, is price gouging observable in the U.S. economy today?
Price Gouging in the Grocery Industry?
- “Food prices in America are under heavy scrutiny … Consumer advocates and government officials have blamed corporate greed for food-price inflation.” – The Wall Street Journal (Oct 16, 2024)
The charge of price gouging is most often aimed at the grocery industry. This is understandable. The grocery aisle is where the consumers directly experience changing prices most frequently. “Food at home” inflation peaked at over 13% in August 2022 – the highest level in five decades – which was especially shocking after several years of nearly flat food prices.
Was this a result of price gouging?
Probably not: Grocery Operating Profits Were Low and Flat
First of all, the grocery business has always suffered from chronically low profit margins. Its average operating profit margin in Q1 2024 was just 3%, compared to an average of 18% for the S&P 500 companies as a whole. The net profit margin for the grocery sector was barely more than 1%.
This implies that there is not much leverage for the changes in retail grocery margins to move the entire consumer price index very much.
Second, and more to the point – the industry’s profit margins did not expand as inflation accelerated. From March 2021 (when the year-over-year CPI first crossed the 2% threshold) until the inflation peak of 9% in June 2022, operating profit margins did not increase.
Grocery Net Profit Margins Shrank
The industry leaders, Kroger (the largest grocery store chain) and Walmart (the largest seller of groceries), saw declines in gross profit margins during the period of rising inflation.
(Gross profit here measures the percentage of each dollar of sales left over after paying just the direct cost of food products from the company’s suppliers – before the grocer’s labor, overhead, and other costs are accounted for. This indicates that the companies’ costs were actually rising faster than their prices.)
Since 2021, Kroger’s dismal net profit margin has never been above 2%. It collapsed below 1% as inflation heated up, recovered, and fell again as inflation cooled off.
Walmart’s net profit margin also declined during the inflationary outburst and never reached its long-term average of 3%.
This makes sense if grocers were holding the line on prices as their costs increased, accepting reduced profitability to avoid penalizing or alienating their customers. This would be the opposite of “price gouging.”
In fact, profit margins dropped across the entire retail sector of the economy during the inflationary episode.
Taking an even broader perspective, profit margins for the entire S&P 500 cohort did not increase during the inflationary surge. As inflation raged, corporate profitability declined steadily, with margins shrinking 20% from 2021 to mid-2024.
The Federal Reserve’s Analysis: There Is No Price Gouging Anywhere?
Economists at the Federal Reserve have studied the trends in profitability metrics for the entire economy over the last several years and have generally found little evidence for corporate profiteering as the driver of inflation. For example, the San Francisco Fed recently published a study which concluded that “changes in markups are not likely to be the main driver of inflation.”
- “…the aggregate markup across all sectors of the economy, which is more relevant for inflation, has stayed essentially flat during the post-pandemic recovery. This is broadly in line with patterns during previous business cycle recoveries. Overall, our analysis suggests that fluctuations in markups were not a main driver of the post-pandemic surge in inflation. (SF Fed, May 13, 2024)
Analysts at the Kansas City Fed reported similar results, noting that “markups fell in the second half of 2021, while inflation accelerated.”
The Richmond Fed published another study that reached the same conclusion: “Changes in profit-taking as reflected in the behavior of markups did not contribute much to inflation.”
Looking across the entire economy, Federal Reserve researchers could find little support for the existence of “greedflation” or price gouging.
An Exception?
There is, however, one industry sector which manufactures a product of critical importance to consumers – where the evidence for “price gouging” appears much stronger. It is the retail banking industry, and its principal product is consumer credit.
“Credit” as a Consumer Good
Banking is often seen as a service, but credit is a consumer product, as real as bacon or gasoline. It is manufactured, packaged, marketed, bought and sold, resold, recycled, and traded, wholesale and retail, as actively as any commodity. It has a purchase price, which is usually referred to as “interest.” That price is subject to the laws of supply and demand, just like, say, the price of crude oil. (It may also be re-priced in secondary markets, where it is traded and repackaged in various ways – but that is another story and not one that consumers directly interact with, as a rule.)
Credit is also pervasive, even fundamental (in a way in which bacon is not). It touches every consumer in many ways. It penetrates every sector of the economy, and forms part of almost every other product and service, and is incorporated into the cost of almost everything we buy. When the cost of credit goes up, it drives up prices everywhere.
The suppliers of consumer credit are legion, from department stores and tech companies, to mortgage brokers and automakers. But above all, banks are the principal manufacturers of credit. Banks nurture, curate and package credit into standard products marketed directly to consumers, including mortgages, auto loans, and credit cards.
[Oddly, the price of credit itself is not included in the calculation of inflation. Interest rates on mortgages, auto loans, credit cards are all subject to inflation – but none of them are included in the calculation of the Consumer Price Index. A significant point, and a topic for another day.]
Viewed through the lens of the profit margin test, the banking industry presents a very different picture from grocery or retail. Margins for the largest banks bulged as inflation accelerated.
At JP Morgan, operating profit margins expanded significantly during the crucial period.
The bank’s net profit margin – the true “bottom line” – ballooned by 73%.
At Bank of America, operating margins also expanded as inflation heated up.
BofA’s net profit margin grew by 85%.
Regional banks showed a similar pattern. Operating margins of the top six regional banks rose 60% during the inflationary surge.
Did these profits come out of the pockets of consumers, and potentially contribute to consumer inflation?
The answer seems to be Yes, based on at least four bits of evidence.
The Evidence for Possible Price Gouging In The Consumer Credit Market
1. Rising Profit Margins on Consumer Credit
Most banks fund themselves principally with consumer deposits, in the form of savings accounts and certificates of deposit (CDs) – for which they pay a low price (interest) to consumers – or checking account balances, for which they may pay nothing at all. Banks employ these funds to offer loans and credit back to consumers (and businesses), in the form of mortgages, auto loans and credit cards, for which they charge a higher price (interest). The cost/return spread of credit products (usually called the “net interest margin” or NIM) is the difference between what the banks pay out and what they take in. It is the basis of the banking business model.
So, how did this model work during the inflationary episode where banks’ profit margins expanded so dramatically?
Average interest rates on credit cards surged upwards in early 2022 when the Federal Reserve began raising its target rate.
Did banks also expand the cost/return spread, the NIM for credit cards, during this period?
Apparently so. The difference between interest paid to consumers on CD’s (one measure of the banks’ cost of funding) and the interest charged on credit cards (a measure of the banks’ return) began increasing as inflation took off, and has grown by 36% since the beginning of 2021.
Since January 2021, credit card balances (what users of credit cards owe) increased 47%, and credit card interest rates (what users pay on the balances they carry) have increased 46% – higher balances and higher rates raised the total exposure to charges on outstanding balances up by 111%. According to the Consumer Financial Protection Bureau, “credit cards have never been this expensive.” By one calculation, had rates remained where they were at the beginning of 2021, consumers would have saved over $300 Bn (even with the increased balances). This is another important component of “true” consumer inflation (missing from the CPI).
(Similar patterns are observed with auto loans and mortgage interest rates, where cost/return spreads increased as the Fed began raising rates.)
2. Depressed Savings Account Interest Rates – $1 Tn Cost to Consumers
A related point: As interest rates in the market rose in response to the Fed’s rate hikes, banks automatically saw higher returns on many of their existing credit products.
- “Loans tend to be floating-rate contracts, benchmarked to reference rates that typically reprice with policy rates [i.e., the Fed’s rate target]. In contrast, payouts on bank liabilities, such as [interest on] deposits, are largely at the discretion of the bank and typically adjust to policy rates at a slower pace.Thus, bank NIMs tend to rise with rate hikes but fall with rate cuts.”
Consumers’ costs of credit have gone up. What has not gone up as fast is the interest rate banks paid out to consumers on CDs and savings accounts.
This phenomenon is well-known. It even has a slangy name: rockets and feathers. When costs go up, prices rise rapidly like rockets. When costs fall, prices come down slowly like feathers. This sort of applies in reverse to interest on consumers savings instruments. Banks reduce the rates they pay out on consumer deposits quickly as Federal Funds Rate falls, but do not increase the pay-outs as rapidly when the Fed rate rises. A 2013 study by two economists at the Fed found that
- “Deposit rate changes are asymmetric: at the institution level, rates adjust about twice as frequently during periods of falling target federal funds rates as they do in rising ones.” [Emphasis added]
When the Fed raises interest rates, banks are able to expand the Net Interest Margin – and consumers pay a price in lost income as the interest rates on their savings accounts is allowed to lag. The researchers concluded that “when rates [of interest paid out on consumers’ savings accounts] are slow to rise, the reductions in interest income to consumers can be considerable.”
How considerable?
- “When interest rates lift off from their current levels near zero, these results suggest that deposit rates are likely to follow very slowly. Over the sample in this paper, the maximum gap between actual and “equilibrium” deposit rates was between 100 and 160 basis points; such a gap would represent a loss to consumers of about $70 billion to $100 billion per year.” [Emphasis added]
A recent study cited by the Financial Times calculated that the cost to consumers may well be much higher – perhaps more than $1 Trillion since the Fed began raising its rate target on March 2022.
- “At the end of the second quarter [of 2024], the average US bank was paying its depositors interest at the annual rate of just 2.2 per cent, according to regulatory data that includes accounts that do not pay interest at all. This is higher than the 0.2 per cent they paid two years ago but far lower than the Fed’s 5.5 per cent overnight rate that the banks themselves can get [on deposits with the Federal Reserve itself]. At JPMorgan and Bank of America, annual deposit costs were 1.5 per cent and 1.7 per cent, respectively, according to this data. Those lower payments to depositors generated $1.1tn in excess interest revenue for the banks.”
This $1 Trillion constitutes a real cost to consumers in the form of higher net payments for credit instruments (loans, mortgages, credit cards) not offset by the missing returns on savings instruments (CD’s, money markets, savings accounts).
3. “Non-Consumer” Banks Don’t Show the Same Profit Margin Expansion
When the banking industry allows its margins to grow, does that actually drive consumer inflation (even if the CPI doesn’t measure it directly)?
Bank of New York Mellon and State Street Corporation are the two oldest private banks in the United States, dating from 1784 and 1792 respectively. Their operating margins expanded somewhat, but much less than the rest of the banking industry.
These two banks have a different business model. They are not involved in retail banking. They earn their profits from other sources (e.g., custody services for other large institutions). They have no consumer deposits from which to extract excess profit and drive up their margins. Without the ability to “gouge” the consumer, these banks saw much smaller increases in their profit margins.
4. Housing Costs
Another indicator of the impact of rising credit costs on the consumer shows up in rising housing costs, largely driven by mortgage rates, set by banks. The Federal Reserve Bank of Atlanta calculates the cost of housing as a percentage of household income. Since the beginning of 2021, the share of household income required to cover housing cost has jumped from 28% to 42% (the average for the decade from 2021-2020 was 29%). This is stark evidence of the importance of interest rates, and banking profits, as a driver of consumer inflation.
Summary
In short, it appears that consumers paid dearly for the banking industry’s expanded profit margins during the inflationary period. Bloated margins for consumer credit during the inflationary surge could support a “price gouging” charge. Moreover, the pervasive role of the cost of credit as a driver of true consumer inflation is significant, even though current metrics like the CPI do not take it into account.
Price Gouging: The Federal Reserve as the Great Enabler
Banking profit margins have now fallen across the board, often to levels well below the long-term average. The “gouging” party would seem to be over.
Was it really “gouging” (such an ugly word)? Or was it simply the mechanics of the interest rate framework adjusting automatically as the Fed started raising rates?
The commercial banks are perhaps guilty at least of having seized the chance to accept fatter profit margins while they could. One could say Why Not? Public companies are not obliged to turn down a “free” profit opportunity.
What we should understand, however, is that the opportunity was created by the Federal Reserve. It is probably going too far to portray the banks as passive beneficiaries, but the Fed’s “rate shock” (as The Economist and others have called it) certainly provided “cover” for the banks to allow their margins on various consumer credit products to expand for a time, driving up the costs for mortgages, auto loans, and credit cards, as well as floating-rate credit instruments for many small businesses who passed those costs along to their customers. All of which helped ignite and fuel inflation.
The Fed’s monetary tightening program was certainly intended to move the cost of consumer credit higher, to “fight inflation” by dampening consumer demand. The expansion of the banks’ profit margins – “price gouging” if that is what it is – may be just another one of the unintended consequences of the aggressive monetary policy.