Huddled in a retreat in a remote Arctic village, European Central Bank (ECB) policymakers last week faced some cold hard facts: Companies are profiting from high inflation, while workers and consumers foot the bill.

The prevailing macroeconomic narrative over the past nine months has been that sharp increases in prices for everything from energy to food to computer chips were ramping up costs for companies in the 20 countries that make up the eurozone.

The ECB responded by raising interest rates by the most in four decades to cool demand, arguing it faced the risk that higher consumer prices would push up wages and create an inflation spiral.

But at the retreat in the Finnish village of Inari intended to give the bank's Governing Council a chance to delve into themes only touched upon at regular meetings, a slightly different picture emerged, three sources who attended the meeting said.

Data articulated in more than two dozen slides presented to the 26 policymakers showed that company profit margins have been increasing rather than shrinking, as might be expected when input costs rise so sharply, the sources told Reuters.

An ECB spokesperson declined to comment on this story.

"It's clear that profit expansion has played a larger role in the European inflation story in the last six months or so," said Paul Donovan, chief economist at UBS Global Wealth Management. "The ECB has failed to justify what it's doing in the context of a more profit-focused inflation story."

The idea that companies have been raising prices in excess of their costs at the expense of consumers and wage earners is likely to anger the general public.

But it has implications for central bankers too.

Inflation fueled by higher corporate margins tends to self-correct as companies eventually put the brakes on price rises to avoid losing market share, making it a very different beast to tame than a wage-price stampede.

So a new inflation narrative focused on margins could give the more dovish members of the Governing Council some ammunition to fight against further rate rises after their resistance proved largely futile over the past year, according to economists interviewed by Reuters.

The debate is due to resume at the ECB's next policy meeting on March 16, when the bank has promised to raise rates to their highest level since the height of the financial crisis in 2008.

Change in narrative

The received inflation narrative in the eurozone has been slowly starting to shift.

Businesses are anticipating smaller price rises as the outlook for costs and demand becomes less clear, according to surveys published by the ECB and Germany's Ifo institute.

Some European countries such as Greece have tabled measures to curb inflation in essential goods while France and Spain are debating similar steps.

"The economics of profitability suggest we might see more of a profit squeeze coming up," ECB chief economist Philip Lane told Reuters. "European firms know that if they raise prices too much, they will suffer a loss in market share."

In the United States, the profit margin expansion started earlier and has already started to reverse, albeit slowly and unevenly.

But unlike the United States, there is no official corporate margin data for the eurozone. Instead, national accounts and earnings reports from listed companies are being used as proxies to paint the inflation picture.

Eurozone consumer goods companies, for example, boosted operating margins to an average of 10.7% last year, up by a quarter over 2019, before the global pandemic and the war in Ukraine, Refinitiv data shows.

The 106 companies included in the survey ranged from French resort owner Pierre et Vacances to carmaker Stellantis to luxury goods group Hermes and Nordic retailer Stockmann.

Similarly, profits rather than labor costs and taxes have accounted for the lion's share of domestic price pressures in the eurozone since 2021, according to ECB calculations based on Eurostat data.

Detached discourse

Indeed, wages have been growing far more slowly than inflation, implying a 5% drop in the standard of living for the average employee in the eurozone compared with 2021, according to ECB's calculations.

That's pretty much the opposite of the wage-led inflation that characterized the 1970s, an era that has become the most widely used point of comparison in the public debate about appropriate central bank policy responses, economists say.

"The public discourse to some extent is detached from what's actually happening out there," said Philipp Heimberger, an economist at the Vienna Institute for International Economic Studies. "The main story of the risks going forward is still that there's a looming wage-price spiral which should make the central bank even more aggressive in hiking interest rates."

For example, wages were mentioned 14 times in ECB President Christine Lagarde's latest news conference while margins didn't get a single mention. Her deputy, Luis de Guindos, also warned that the ECB needed to be careful because labor unions might demand excessive pay rises.

"You see a very clear reluctance to discuss profit," Daniela Gabor, a professor of economics and macro-finance at the University of West England in Bristol. "That illustrates that the distributional politics of inflation targeting is: You don't go for profits; you don't go for capital."

In the United States, the issue of runaway margins has been raised by former Federal Reserve Bank vice-chair Lael Brainard, who is now President Joe Biden's top economic adviser, and Democratic senators Elizabeth Warren and Bernie Sanders.

Even inside the ECB, labor representatives demanding higher pay for central bank staff have distanced themselves from what they described as the institution's "anti-worker bias".

They cited, among others, a paper by researchers at the International Monetary Fund showing that accelerating wages have not historically led to a wage-price spiral.

Profit vs wages

ECB policymakers gathered in Finland went through similar data sets showing that profits had outpaced wages thanks to savings built up during lockdowns being spent, but also because of companies' power to set prices, the sources said.

With those savings now being depleted and competition returning, things may be changing for ECB policymakers who have been calling for a redrafting of the inflation narrative.

In January, Portuguese central bank governor Mario Centeno was among the first to warn about the risk of a very clear increase in profit margins, saying it should be brought up the European policy agenda.

ECB board member Fabio Panetta later said workers had borne the brunt of the surge in prices while, on balance, company mark-ups had remained stable, or even increased in some sectors.

Wages are accelerating, with the ECB's forward-looking wage tracker anticipating a rise of nearly 5% in 2023 for contracts signed in the last quarter of 2022. But that won't offset the massive drop in real wages over the past year, analysts said.

"A key missing ingredient is the bargaining strength of the labor movement, which is structurally weakened by the disinflation policies of the 1980s and the ensuing liberalization of labor markets," said Mattias Vermeiren, a professor of international political economy at the Ghent Institute for International and European Studies.

During the last inflation crisis in the 1970s, nearly 70% of economic output went to employees, with just over 20% going to profits, according to Eurostat data. Now, labor’s share stands at 56% with a third going to profits.

The ECB policymakers went over those differences at their Finnish retreat, though their tentative conclusions were dotted with caveats, the sources who attended the meeting said.

Some argued that furlough schemes during the pandemic may buttress incomes, the sources said, and that a sustained period of high inflation may raise salary demands in a way that models developed during periods of stable prices fail to predict.

And the interest rate doves might have their work cut out after data showed inflation in France, Spain and Germany exceeded expectations last month.