Business inflation expectations cool
The following represents the fourth installment of KPMG Economics Insights on Inflation, a multiyear survey of KPMG clients and other business leaders to understand their responses to the inflationary environment we are now enduring. The fourth wave of the quarterly survey was conducted from May 2 to May 19, 2023. It is focused on business executives and provides a more complete assessment of the temperature of the economy than surveys of consumers alone.
Our findings suggest inflation expectations continued to trend down both one- and five- years out. More than 80% of survey respondents are feeling the pinch of tighter credit conditions and expect the economy to fall into a recession during the next twelve months.
For the first time since this survey began, the inflation expectations of businesses have synchronized with those of consumers one-year out. Since the first quarter of this year, consumers have maintained a steady outlook on inflation. Meanwhile, businesses have lowered their own inflation expectations. The lowered inflation outlook among businesses is likely due to a common belief that a recession will occur within the next 12 months.
Expectations for inflation by businesses one-year out fell more than five years out. The dispersion for inflation expectations continues to be greater across industry groupings five years out than one-year out.
Four factors topped the list of major drivers of their expectations for inflation: demand, competitive pressures, unit labor costs and change in material prices. Businesses continued to cite investments in labor-saving technologies as their preferred way to contain costs. Generative AI has the potential to accelerate those investments.
Most industries expect unit labor costs to exceed inflation, which could portend margin compression.
The following compares the results of KPMG Economics Insights on Inflation survey with the University of Michigan Surveys of Consumers. Both surveys cover a similar period in May.
One-year inflation expectations Five-year inflation expectations
Among the industries surveyed, professional, scientific, and technical services along with finance and insurance lead one-year out inflation expectations of businesses surveyed. While inflation expectations have dropped for most of the industries, professional, scientific, and technical services continues to have the highest inflation expectations both one- and five-years out.
The professional, scientific, and technical services sector also had the largest shift over the quarter, with inflation expectations dropping to 4.6% one-year out, a full percentage-point below the readings for the first quarter.
Five-year inflation expectations for professional, scientific, and technical services have experienced a relatively smaller decrease of 0.2 percentage points to 4.0%. The drop in inflation five-years out is smaller across sectors than we see one-year out. That is not unusual. A similar pattern can be seen across consumer expectations (see Chart 4).
The retail sector has experienced the largest deceleration in inflation expectations for one year out, with a decrease from 7.0% in the first wave to 4.6% in the current quarter. The health care sector has the lowest inflation expectations over the five-year horizon.
Demand was most cited for the reason behind the drop in inflation expectations in the first and second quarters of 2023. This reflects a weakening of overall economic conditions in the first quarter and a more rapid cooling in producer prices than consumer prices. (see Chart 5)
The market volatility of the last few months has forced businesses to consider the impact of rising interest rates. The respondents who believe central bank policy is an influential inflation factor jumped from 46% to 55% since last quarter, which suggests the Fed is getting some credit for the cooling of inflation we are experiencing.
Environmental, Social and Governance (ESG) regulations and COVID have consistently ranked low as a determinant of inflation expectations. The World Health Organization declared that COVID-19 is no longer a global health emergency; the price uncertainty associated with COVID-19 has receded to the lowest on record for the survey.
Factors that shape the business view on inflation
Percentage of total companies who rate "influential" and "very influential"
Labor costs remained a top concern across industries. Expectations for unit labor cost increases have remained relatively stable at 5%. This is close to the 4.8% increase we saw in the Employment Cost Index (ECI) in the first quarter and suggests that labor costs will remain elevated in the second quarter. The ECI averaged slightly less than 3% prior to the pandemic.
Unit labor costs have come off the highs we saw in 2022 but remain elevated across firm size. They are now slowing more rapidly in mid-sized firms than small or large firms; it is unclear whether that is due to productivity gains or a slowdown in compensation (see Chart 6). Those shifts, coupled with the drop in inflation expectations, could signal margin compression (see Chart 7).
Most industries, except for the information sector, anticipate wage growth to remain at similar levels as their expectations in the first quarter of 2023. The information sector, which includes tech and media outlets, has experienced more high-profile layoffs announcement in recent months; the survey reflects that stress.
Expectations in Unit Labor Costs change by company size
Increase in Unit Labor Costs by industry over the next 12 months
Overall, the percentage of rising business costs being passed on to consumers has remained steady at 75%. This suggests that businesses are still able to shift a significant portion of the burden of higher costs onto consumers. The outliers are healthcare and social assistance and information; those sectors expect to pass less than 50% of rising costs onto consumers (see Charts 8-9).
Share of cost change to pass on to customers in the next 12 months
Share of change in costs to pass on to customers by firm size in the next 12 months
Company size by annual gross revenue
Investment in labor-saving technologies has consistently been the number one method that firms choose to reduce costs. Reducing labor turnover is also a priority but has faded in popularity with a slowdown in quit rates (see Chart 10).
The percentage of companies implementing remote work has stabilized at about 40% of survey respondents. The work from home genie is not going back into the bottle; even firms who have required workers to return are still reducing their office footprints. This matches the trend in advertisements for fully remote work, which have declined over the last year. Employers have shown more interest in in-person work than job seekers, but the gap is narrowing.
Outsourcing personnel and offshoring are ranked low on the list to reduce costs. Supply chain disruptions have eased, while geopolitical tensions are increasing the cost of offshoring.
Percentage of total companies by labor cost control method
A whopping 81% of the respondents believe that a recession will occur within the next 12 months. A recession is widely expected across firm sizes and industries. The real estate and finance sectors, which are the most sensitive to interest rate hikes, were more pessimistic on the outlook for the economy.
Nearly 80% of respondents believe that credit conditions will tighten over the next 12 months. Small firms are more likely to expect credit tightening than mid-sized and large firms.
The survey results reflect the Fed’s continued effort to tighten credit conditions. This will likely result in a recession. That effort and falling demand are some of the primary reasons that inflation expectations among businesses are falling.
The fourth installment of the KPMG Economics Insights on Inflation survey suggests that inflation will cool, but at a price. Tighter credit conditions are widely expected to precipitate a recession, which is in line with forecasts for a “mild recession.” Chairman Powell was hoping for a softer landing scenario, meaning cooling down of inflation without a sharp economic downturn. However, the survey’s results suggest that the tightening of credit conditions may make it more challenging to achieve.
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