Well, this may seem a strange day to write about inflation – I just read this morning that fixed-rate mortgage rates have dropped this week to the lowest level this year, with a 15-year available at 3.75%. However, it doesn’t do much good to dwell on the past or present – we should always be considering other scenarios in the future to stay ahead of the competition.
One topic which seems to draw much discussion, as well as confusion right now is inflation. I’m not interested in talking about what the Fed could or couldn’t do to ease inflationary concerns or who screwed up the economy to get us where we are today – that doesn’t seem productive, because it doesn’t do much to help our business community. What I’ll attempt to do is highlight what to watch out for and consider some of the possible effects of high inflation on Oklahoma businesses.
First, how could we tell if we were in a period of high inflation?
Depending on your business, you may first notice price increases in commodities or raw materials (price inflation). Alternatively, you may see interest rates start rising in response to an increase in the money supply from the Federal government (monetary inflation), but common sense suggests that you’ll first see prices moving higher before monetary inflation. Most commonly, people use the CPI as an indicator of price inflation, because it consists of a basket of goods, but there are clues all around us to price rises.
Commodities are an obvious example of price inflation. If we use a critical example to Oklahoma’s economy, rising oil prices can contribute to price inflation, because so many goods and services are affected by the price of oil. Unfortunately and incorrectly, oil producers are often blamed for rising prices when they are not actually the source of price rises. Yes, they benefit from higher prices, but they do not cause them. Speculators bid up futures prices, believing that the future price of oil will be higher. The spot (market) price of oil then rises as a result.
Less obvious are price increases in many other goods or services, but as overall prices of goods and services rise, the Fed will accommodate the higher prices and increased demand for more money to pay for those goods and services by increasing the money supply.
Second, how does inflation affect us?
Inflation never affects everyone equally. It shifts buying power from one group to another. And if we are looking at this from the perspective of a business, we want to understand how it could be affected by inflation.
1) Money loses value. In periods of high inflation, money you have saved in the bank loses value, unless you are earning higher interest rates than the underlying rate of inflation. As a result, businesses may be inclined to spend money before it loses value. Businesses may also seek to borrow money on the assumption that price inflation will allow them to pay off the loan when money is worth less in the future. On the flip side, inflation causes uncertainty, in particular about future interest rates on debt, so some businesses may be less willing to make significant capital expenditures.
2) Interest rates. At banks and commercial lenders, lending rates rise significantly in periods of high inflation. Lenders still have their targeted risk-based rates of return, which will be matched to the prevailing inflation rate. As a very simplified example, a 5% loan rate in a period of 0% inflation would likely be adjusted to a 10% loan rate in a period of 5% inflation.
3) Employee issues. Employees seek higher salaries in periods of high inflation, due to the higher cost of goods and services. Employees always want pay rises, but in periods of high inflation, it becomes a hot button topic that can have far reaching consequences. Employee wage demands lead to negotiations, which takes managers’ time away from running the business. Wage demands also cause distractions and tension among employees and it’s not uncommon for employee morale and productivity to decline in periods of high inflation, unless managers take proactive steps to mitigate these risks. It is important to communicate with your employees early and often about your business’ capacity or more likely incapacity to provide significant wage increases.
4) Input prices rise. Raw materials, supplies and wages all tend to increase in periods of high inflation, which almost inevitably puts downward pressure on the profitability of the business. If prices do rise, then business managers need to anticipate, track and perhaps consider hedging rising costs and where possible, pass them on their customers. In particular, businesses should be wary of signing fixed price contracts with customers for anything more than a few months, otherwise a profitable contract could quickly become a loss making contract. In turn, all the way along the supply chain, businesses will try to pass on increased costs and at some point, supply chain participants will be unable to absorb or pass along the rising costs, which will lead to business failures. The unintended consequence for customers in some markets is that their refusal to accept price increases from their vendors, may lead to vendor failure, a subsequent reduction in supply, which then leads to additional price increases due to a supply-demand imbalance.
5) Trade deficit/Imports and Exports. If the US has higher inflation than other countries, then US exports become increasingly expensive, while imports become cheaper. This would further exacerbate the US trade deficit as US goods would become increasingly expensive to foreign buyers and many US businesses would choose lower priced imported goods over goods produced domestically. Of course, if inflation is higher outside the US, the reverse is true.
6) Bubble assets and businesses. As investors look for safe havens for their money, bubbles are created in certain asset classes. This can have a positive effect on select niche businesses that sell goods or services to that bubble, but a negative impact for most other companies. Later, of course, the bubbles will burst and the sharp revenue declines for bubble-impacted businesses and the unwinding of high spending on growth initiatives will lead to business failures when the bubble bursts.
7) Elasticity of businesses. If the US were to enter a period of high inflation in the near term, one additional problem is that many companies are already operating efficiently, having trimmed the fat, reduced overheads and tightened the ship just to get through the storm of the last few years. As a result, there is currently less elasticity for businesses to cope with high inflation. In many ways, a company’s ability to perform in times of high inflation depends on its ability to control their costs and pass on price increases to their customers, but it still requires some room for maneuvering while those negotiations take place.
It seems that I often seem to write negative stories, but that’s not my intention. I’d just rather be talking about topics that have value for business owners to consider for the future. It may be that the US avoids high inflation altogether, which would be great, but isn’t it better that we start talking about what to do in different future scenarios?