Ivan Yotzov, Nicholas Bloom, Philip Bunn, Paul Mizen, Ozgen Ozturk and Gregory Thwaites
Since late 2021, annual CPI inflation in the UK increased sharply. Alongside this increase, there was also a significant rise in firm and household short-term inflation expectations. In this post, we use data from the Decision Maker Panel (DMP), a UK-wide monthly business survey, to study whether there is an effect of CPI data releases on firms’ current inflation perceptions and year-ahead inflation expectations over the past four years. We find that on average firms’ perceptions of current CPI inflation have been close to the eventual outturn. Furthermore, one-year ahead own-price expectations respond significantly to CPI outturns, with the effects being particularly strong since the start of 2022.
The nature of expectations formation by firms can have important implications for the path of inflation going forward. Indeed, inflation expectations play a key role in price setting behaviour in most modern macro models. Past research has analysed the effects of data releases and policy announcements on inflation expectations, with a particular focus on households due to the availability of data. Binder (2021), for example, shows that only inflation expectations of highly numerate households respond to CPI releases. A number of studies have considered how households and firms react to monetary policy decisions, using data from the US, Germany, and Italy. In the UK, recent research using the DMP has shown that firms’ expected price growth responds significantly to monetary policy decisions by the Bank of England. We contribute to this literature by documenting the attentiveness of firms to CPI trends and analysing the varying responsiveness of price expectations during low versus high inflation periods.
The Decision Maker Panel (DMP)
The DMP is a monthly business survey of UK businesses, with around 2,500 respondents each month. Importantly, the DMP covers firms across the whole economy, not just consumer-facing ones. The survey is frequently used to study business trends across the country and advise policymakers, including on the impacts of uncertainty around Brexit, Covid-19, and the Russia-Ukraine war. Firms are regularly asked about their annual own-price growth and price growth expectations for the year ahead. In addition, since May 2022, firms have been asked about their perceptions of current CPI inflation as well as their one-year and three-year ahead CPI expectations. As shown in Chart 1, firm price growth has increased significantly over the past two years and own-price expectations are also elevated. In March 2023, firms expected their prices to increase by 5.3%, on average, over the next 12 months. Meanwhile, one-year ahead CPI expectations were 5.8% in March 2023, down from a peak of 9.5% in September 2022. Although firm price growth and CPI inflation are positively correlated, it is important to highlight these are distinct concepts. CPI is the average price inflation of consumer goods and services, weighted by their importance in a representative ‘shopping basket’. Annual firm price growth is the average price inflation across (consumer and non-consumer facing) firms in the economy, weighted by industry and employment shares.
Chart 1: UK CPI inflation and firm-level price growth
Current inflation perceptions and CPI outturns
We begin by comparing CPI inflation with firms’ current CPI inflation perceptions. As shown in Chart 2, average CPI perceptions have been between -0.5 and 0.4 percentage points of actual CPI inflation in each month over the past year. For example, in January 2023 the annual CPI inflation rate was 10.1%, whereas the average CPI perception among DMP respondents was 9.8%. Nevertheless, there is notable heterogeneity in perceptions at the firm level: survey respondents in larger firms and more productive firms, in particular, are more likely to be accurate in their estimates of current inflation.
Chart 2: CPI inflation and average current CPI perceptions
Own-price expectations and CPI outturns
To test the effect of CPI data releases on firms’ own-price expectations, we use an event study methodology. Specifically, we leverage the fact that CPI data are usually released on the second Wednesday within the (two-week) DMP survey window. This allows us to compare average own-price expectations in the days before versus after the release because we can observe the date and time that a firm responded to the survey.
More formally, we estimate the following regression using our firm-level data set and focusing on a window of two days before and after a CPI release:
For firm i, responding to the survey in month m on day j of the event window, the dependent variable is a measure of year-ahead own-price expectations. The coefficients of interest on the right-hand side are λκ, which capture the impact of the change in CPI in each day of the event window (where we use the day prior to the release, k = -1, as the reference category). In addition, our specification controls for month fixed effects, αm, and event-window fixed effects, γj. The month fixed effects capture secular trends in expectations and CPI for all firms, and the event-window fixed effects would capture common response patterns in the event window (eg inflation expectations being systematically higher on Fridays, if this were the case).
In 2022–23 we find that CPI data releases have a positive and significant effect on firms’ own expected price growth in the days following a data release, as shown by the coefficient estimates at t + 1 and t + 2 in Panel A of Chart 3. These results are quantitatively meaningful as well: a 1 percentage point increase in CPI is associated with an almost 1 percentage point increase in expected own-price growth in the days following a release. It should be noted that this strong reaction may decline over time, but the structure of the survey does not allow us to easily analyse the effects over longer event windows. Furthermore, we find stronger effects when analysing changes in headline CPI inflation than changes in CPI relative to market expectations (proxied by median forecasts of CPI inflation by qualified economists in Bloomberg). This suggests market expectations may be a poor proxy for firm expectations. Finally, we find no significant effects in earlier years of the data, suggesting the increased responsiveness to CPI outturns is a feature of an environment of elevated inflation (Panel B of Chart 3).
Our findings would be consistent with a ‘rational inattention’ model: in the current high-inflation environment, firms may be paying more attention to inflation outturns, and are thus more responsive to news than in the previous low-inflation environment. However, this is not the only possible explanation. A related theory is that firm pricing behaviour becomes more flexible in times of increased volatility. This could again lead to higher responsiveness to CPI outturns, but not necessarily due to increased ‘attentiveness’. Indeed, firms in the DMP report that their frequency of price adjustment has increased in 2022 compared with 2019. Finally, the results may suggest that firms are becoming more backward looking in their expectations formation. Research using UK data has shown that backward-looking behaviour has been common in past episodes of high inflation (eg 1970s oil price crises). With more data, we will be able to further explore these competing explanations, particularly as inflation returns to lower levels. The precise mechanism of expectations formation, as well as the presence or absence of asymmetries in the adjustment, can also have important implications for policy going forward.
Chart 3: Effect of CPI outturns on own-price expectations
Panel A 2022–23
Panel B 2018–21
CPI expectations and CPI outturns
Finally, we consider the effects of CPI outturns on one-year ahead CPI expectations by firms. As shown in Chart 4, we find no significant effect on year-ahead CPI expectations. This may suggest firms perceive CPI inflation as less persistent, and therefore do not update their expectations based on realised outturns. Alternatively, it may be that firms’ CPI expectations (an aggregate measure of price increases) are influenced by different factors compared with own-price expectations (a firm-specific measure of price increases). Indeed, when we asked firms directly about the factors influencing their CPI expectations in the year ahead (see Chart 5), the overwhelming majority cited energy prices as a key influence (69% of respondents). There is evidence from previous research that energy prices are more salient than other price increases for households and the same may be true for firms. In contrast, the factors influencing own-price expectations are more balanced, with the largest proportion of firms citing labour market considerations, followed by rising non-energy costs.
Chart 4: Effect of CPI outturns on one-year CPI expectations (May-22 to Feb-2023)
Chart 5: Factors influencing CPI expectations
Conclusions
We study the responsiveness of firms’ inflation perceptions and expectations using data from the Decision Maker Panel. We find that firms have been attentive to CPI outturns over the past year, and update their current CPI perceptions responding to announcements in CPI monthly data releases. Own-price expectations also respond to CPI outturns, but only during the recent period of high inflation and not in previous years. Looking ahead, it will be crucial to monitor the responsiveness of firms’ expectations as inflation begins to decline in 2023. High responsiveness may indicate a faster slowdown in firm price growth if the effect is symmetric for inflation increases and decreases. However, a decline in responsiveness could signal more persistence of inflation in the near term.
Ivan Yotzov, Philip Bunn and Ozgen Ozturk work in the Bank’s Structural Economics Division, Nicholas Bloom works at Stanford University, and Paul Mizen and Gregory Thwaites work at University of Nottingham.
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