evidence from the Decision Maker Panel – Bank Underground

Ivan Yotzov, Nicholas Bloom, Philip Bunn, Paul Mizen, Ozgen Ozturk and Gregory Thwaites

Inflation in the UK is currently at its highest level for 40 years. Alongside the increase in inflation, there has also been a significant increase in short-term inflation expectations. The nature of expectations formation by firms can have important implications for the path of inflation going forward. 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. We find firms are accurate, on average, in their perceptions of current CPI inflation. Furthermore, one-year ahead own-price expectations respond significantly to CPI outturns, with the effects being particularly strong since the start of 2022.

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.

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, firms have been quite accurate, on average, in their perception of current CPI inflation 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.

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. 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 aggregate inflation is a new feature of firms’ expectations formation (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 trends, and are thus more responsive to news than in the previous low-inflation environment. If this high attentiveness continues as CPI begins to recede, the results may suggest that firms adjust their own price expectations down quite rapidly. 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. If this were the case, it could imply a slower downward adjustment in expectations going forward. With more data, we will be able to further explore these competing explanations, particularly as inflation returns to lower levels.

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 2022 to February 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 because firms become more backward looking could signal more persistence of inflation in the near term. Overall, our findings contribute to the understanding of the dynamics of inflation expectations formation among firms, which is crucial for policymakers to make informed decisions.

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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