The Big Idea
Looking at business inflation expectations
Stephen Stanley | January 21, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The Federal Reserve spends a great deal of time and energy examining inflation expectations, which are viewed as a key if not primary driver, of longer-term inflation. Policymakers get a read on households’ and economists’ expectations through surveys and on market expectations through TIPS breakevens. The Atlanta Fed also surveys businesses in its district on their inflation expectations. Examining inflation through the lens of price setters offers helpful insight into the Fed’s likely difficult task of bringing price hikes back under control.
Atlanta Fed survey of business inflation expectations
The Atlanta Fed has created a number of data series that have proven useful to financial markets and others interested in the economy including the GDPNow calculation, the Atlanta Fed wage tracker, and the Sticky-Price CPI. Another useful effort by the Atlanta Fed is the Business Inflation Expectations survey.
Each month during the week CPI is released, the Atlanta Fed sends a survey to about 300 businesses of various sizes headquartered in its district. The responses are then weighted by industry share of GDP to ensure a realistic representation across economic sectors.
Among other questions, each respondent is asked to project the change in their business’s unit costs over the next 12 months. Or, more precisely, they are offered five different ranges—down more than 1%, plus or minus 1% to unchanged, up 1% to 3%, up 3% to 5%, and up more than 5%–and asked to assign a probability to each. From the responses, researchers calculate a mean, a median, a mode, and the variance of responses. In addition, once a quarter, panelists are also asked to project the rate of change of their unit costs for the next five to 10 years. The Atlanta Fed has created a series of businesses’ expectations of their unit costs that replicates the year-ahead and long-term inflation expectations results from the University of Michigan survey of households.
It is worth noting that the Atlanta Fed asks directly about firms’ unit costs, not the prices they intend to charge. In a sense, this survey is one step removed from an “inflation expectations” survey. However, inquiring about unit costs is still a valuable exercise, as businesses generally set their prices based on their expectations regarding their costs and some sense of what the market will bear. The second factor is, of course, highly uncertain, but over long periods of time, presumably final prices will rise or fall in rough proportion to changes in unit costs Otherwise, profit margins would fall to zero or widen without end. The Atlanta Fed results become a decent proxy for businesses’ estimates of underlying inflation pressures.
The most recent monthly results, from the survey conducted in January, show that businesses on average expect their unit costs to increase by 3.4% over the next 12 months (Exhibit 1). It ran at roughly 2% for a decade before dipping in early 2020 and has steadily accelerated since then, reaching its current level, a record high, in December. The responses were roughly evenly split between three of the five groupings, with close to 30% each expecting a 1% to 3% rise, a 3% to 5% increase, or a jump of more than 5%. Interestingly, while the level of expectations has trended up, the variance of responses is actually at its lowest in the 10-year history of the survey, which suggests that an elevated pace of cost increases is being endured by a high percentage of businesses of all sizes and in all industries.
Exhibit 1: Atlanta Fed year-ahead business inflation expectations
The fluctuations in the longer-term business inflation expectations series have been more restrained. The series ran just below 3% for most of the past decade, dipped in the early days of the pandemic, and have accelerated sharply since late 2020 (Exhibit 2). In the most recent quarterly survey, in December, the average expectation increased from 3.0% to 3.2%, the first time that the series has ever exceeded 3%.
Exhibit 2: Atlanta Fed long-term business inflation expectations
The January 2022 survey also asked a few special questions regarding firms’ workforce and expectations of wages. The expectations regarding wage changes for the next year were especially noteworthy. Respondents anticipate that their low-skill workers will, on average, see 10.2% gains in hourly wages over the next 12 months, while high-skill workers are expected to see 6% advances on average.
Corroboration from the North
The Philadelphia Fed regional survey of manufacturers happened to include a similar set of special questions this month. The results, released on January 20, showed that manufacturing firms anticipate elevated cost increases for 2022. The average expected change in energy costs (6.4%), other raw materials (8.9%), intermediate goods (6.4%), and wage and benefit costs (6.4%) are all quite elevated. In each case, a strong majority of firms expected the rises in 2022 to be larger than the actual cost changes seen in 2021.
The narrative that the inflation bulge in 2021 was predominantly transitory and driven by fleeting supply-side bottlenecks has largely crumbled in recent months. The survey results detailed above offer further proof that higher inflation is likely to have legs. Cost increases are not expected to recede much this year, which presents clear upside risk that any deceleration in price increases could be far smaller than generally expected.
Last week, an economist at the Atlanta Fed, Brent Meyer, was interviewed by Market News International regarding the results of the January Business Inflation Expectations survey. He noted that “I’m starting to be very concerned about what we’re seeing in inflation expectations now.” He cited the wage expectations noted above as evidence that “wage growth has become more broad-based.” He hesitated to invoke the prospect of a 1970s-style wage-price spiral, but he said that “that sort of dynamic is not too far off from what could potentially happen.” He also added that a few firms in the Atlanta Fed District have started to report that their sales were insensitive to price hikes as large as 10%, a sign of sustained robust demand.
In light of the fact that the headline business inflation expectations readings are still only just above 3%, it would appear that, similar to the University of Michigan household survey results and TIPS breakevens, longer-term inflation expectations, while on the high side, are not an urgent problem. However, the underlying detail offers more cause for concern. It appears that labor costs are actually accelerating at a much faster pace, and firms have already demonstrated that, in the aggregate, they have significant pricing power to pass those rising costs along to their customers.