Ivan Yotzov, Philip Bunn, Nicholas Bloom, Paul Mizen and Gregory Thwaites
Inflation in 2023 remains elevated across many advanced economies. Existing studies have considered the contribution of profits to persistently high inflation in the US, euro area and UK. To add to this debate, we recently asked firms in the Decision Maker Panel about their profit margins over the past year and their expectations for the year ahead. This post summarises the key findings from these new questions, and links them to recent trends in prices. Firms reported a squeeze in profit margins over the past year, on average, but they expect to rebuild margins over the next year. Firms expecting to increase margins also expect slightly higher price growth, suggesting that margin rebuilding could make some contribution to inflation persistence.
The Decision Maker Panel (DMP) is a monthly survey of CFOs/financial directors in firms across the UK. It receives around 2,500 responses each month. The survey is frequently used to study business trends across the country and advise policymakers. Recent work using the DMP has analysed inflation during the Covid pandemic, firms’ responsiveness to CPI outturns, and firm price-setting behaviour. Since May 2023, firms were also asked about the evolution of their profit margins (defined as operating profits as a share of sales) over the past year, and their expectations for margins over the year ahead.
Recent trends in firm price growth
Firm annual own-price growth appears to have peaked around the end of 2022 and has begun to decline in recent months. In the three months to July, annual price growth across firms in the DMP was 7.4%. Looking ahead to the next 12 months, firms expect their own-price inflation to fall by around two percentage points (as seen by the gap between the navy and maroon lines in Chart 1). Average expected price growth was 5.2% in the three months to July 2023.
Chart 1: Firm annual price growth, expected price growth, and CPI inflation
When comparing the DMP and CPI inflation trends, it is important to note that the DMP covers prices set by firms across the whole economy, whereas CPI focuses on prices of consumer goods and services only. Certain sectors (eg energy, food) have a greater weight in the CPI basket than in the DMP sample, which can help explain the deviations between these two measures over the past year. This can help to explain why annual CPI inflation increased sharply during 2022 (Chart 1), and also why it may fall by more than the DMP measure over the coming months.
Firm profit margins
Firm-level data on profit margins are typically only available with a lag of at least a year due to the delay in publication of firms’ accounts. Two new questions on firm profit margins added to the DMP survey in May 2023 provide timely data to fill this gap, and they also allow us to study firms’ expectations of profit margins for the year ahead. Moreover, these data allow us to assess which types of firms are seeing their margins rise or fall and to look at whether the firms seeing an increase in margins are also firms who are raising prices the most.
Recent work has highlighted the importance of the precise measurement of profits, as well as the differences between national and firm accounting (see, for example, a recent speech by Jonathan Haskel). This is discussed in detail in a recent Bank Underground post, which also compares measures from firm-level accounts data with aggregate national accounts. It shows that the two comove, at least over the last 20 years, although the firm series are more volatile, on average.
Chart 2: Changes in profit margins over the past year and historical comparisons
Panel A: Changes in profit margins
Panel B: Distribution of profit margins using firm accounts and DMP data
Drawing on data from the DMP survey, Chart 2, Panel A shows that 41% of firms reported that their profit margins had declined over the year between 2022 Q1 and 2023 Q1, and 26% reported large declines (navy bars in Chart 2, Panel A). In contrast, around one third of firms reported their profit margins increased.
Looking to the year ahead, firms expect some increase in margins. Forty-five per cent of firms expect their profit margins to increase in the next 12 months, compared with 32% that expect no material change and 23% who expect profit margins to decline (maroon bars in Chart 2, Panel A).
To try to put these recent developments in margins into a historical context, we can compare them with firm accounts data up to 2021 (Chart 2, Panel B). Specifically, this Chart tracks the historical trends in profit margins for the same firms for which we also have data for in the DMP survey. It furthermore splits these trends across different percentiles of the distribution (calculated at the yearly frequency). The solid lines indicate data from firm accounts, and the dashed lines indicate the implied changes in margins in financial year 2022 (which runs to 2023 Q1) and the expected change in 2023 (which runs to 2024 Q1), based on the latest data from the DMP. The level of profit margins reported in the DMP was higher than accounts data where comparable data exist; we therefore splice changes in margins from the DMP onto the last accounts data rather than showing the actual levels from the DMP.
Looking at firms’ accounts, profit margins declined in the first year (FY) of the pandemic (FY2020) and then recovered in FY2021. This drop was present on average (black line), but most pronounced at the bottom of the distribution (navy line). The latest data from the DMP suggest profit margins declined slightly in FY2022, and that firms expect a rebuild in FY2023. However, these patterns vary across the distribution: firms at the 10th percentile reported the largest drop, and they only expect a partial recovery. In contrast, there has been less of a squeeze in the upper part of the distribution. For example, margins in the 90th percentile are flat over FY2022 and are expected to increase in the year ahead.
Going beyond aggregate trends, we next consider how changes in profit margins relate to other firm-level variables. We highlight three important relationships here. First, the relationship between annual price growth and changes in profit margins in the cross section is only weakly positive (Chart 3, Panel A). However, we find a strong positive relationship between annual real sales growth and changes in profit margins (Chart 3, Panel B). Note that these Charts are binned scatterplots, where each dot represents 3% of observations, or around 48 firms. Finally, there is also a negative correlation between unit cost growth and changes in profit margins.
Chart 3: Changes in profit margins over the past year
Panel A: Change in profit margins and annual price growth
Panel B: Change in profit margins and real sales growth
It is important to emphasise these relationships are correlations, and do not necessarily reflect a causal underlying mechanism. But, they do highlight that factors beyond price growth, such as demand and costs, can also have important impacts on margins at the firm level. Increases in demand, could for example, be associated with a reduction in average costs if firms face increasing returns to scale. Past work using the DMP finds that energy prices, supply disruptions, and labour shortages have been the largest recent drivers of inflation since 2021.
Looking ahead, firms expect some increase in their profit margins (Chart 2, Panel A). The expected improvement is broad-based across sectors of the economy. At the firm level, we find that firms who have experienced bigger falls in margins over the last year, expect more of an increase next year (Chart 4, Panel A). Like Chart 3, Chart 4, Panel A is a binned scatterplot, where each dot represents around 57 firm-level observations.
Chart 4: Realised and expected changes in profit margins
Panel A: Realised and expected change in profit margins
Panel B: Expected year-ahead price growth by expected change in profit margins
Finally, we find some evidence that firms that expect to increase margins also expect higher price growth over the year ahead (Chart 4, Panel B). This is particularly evident for firms that expect a large increase in margins. These differences suggest that margin rebuilding could make some contribution to inflation persistence going forward, although the implied magnitudes are relatively small given that only 13% of firms expect a large increase in margins. This relationship is also not necessarily causal, and the changes in margins and price growth could both be driven by a third factor. These impacts are already factored in to the average expected price growth presented in Chart 1 and suggest that expected inflation may have been slightly lower in a counterfactual world without margin rebuilding. We also find that expected real sales growth is robustly positively correlated with expected changes in profit margins and the relationship with expected unit cost growth is weakly negative. Therefore, monitoring all of these variables will be important to understand how margins evolve.
Summary
Firms in the DMP were recently asked about developments in their profit margins over the past year and about what they expect for the year ahead. On average, firms experienced a squeeze in margins between 2022 Q1 and 2023 Q1, and they expect to rebuild profit margins over the next year. Real sales growth has the strongest positive correlation with the evolution of margins. However, firms that expect to increase margins also have slightly higher expected price growth for the year ahead, suggesting margin rebuilding could make some contribution to inflation persistence.
Ivan Yotzov and Philip Bunn work in the Bank’s Structural Economics Division, Nicholas Bloom works at Stanford University, Paul Mizen works at King’s College London and Gregory Thwaites works at the University of Nottingham.
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This is a very interesting and welcome addition to the Bank’s suite of information for working out where the economy is and where it is going. But bearing in mind that the Bank’s Agents conduct about 9,000 personal meetings with firm decision-makers which take advantage of personal relationships and the opportunity to follow up and check the answers they are getting via in-depth interviewing, it would be very valuable if attempts were made to compare and cross validate the two data sources. Social scientists have established that survey methods, compared to standardised nonschedule interviews of the kind the Agents conduct, have relative advantages and disadvantages as reliable and valid sources of inference. By far the most powerful way forward is to make comparisons. See https://www.bankofengland.co.uk/working-paper/2020/monetary-policy-and-the-management-of-uncertainty-a-narrative-approach