What Are Inflation Effects?
Although inflation can reduce the purchasing power of individuals and businesses, it is not always a cause for alarm. Economists believe that a modest level of inflation is necessary for a healthy and expanding economy. To achieve this, the Federal Reserve, the central bank of the United States, targets an annual inflation rate of 2%. This rate is considered optimal because it allows for steady economic growth without the risk of higher unemployment. However, if the inflation rate falls too low, the economy may stagnate, while if it rises too high, it can cause unpredictable effects that can ripple through the economy, influencing the behavior of buyers both rationally and emotionally.
The fundamental principle of supply and demand underpins all the effects of inflation on businesses, no matter how far-reaching or complex they may become. At the most basic level, if the money supply in an economy is too high compared to the number of goods and services available for sale, prices will inevitably rise. The Federal Reserve uses an "inflation-targeting" monetary policy, which is designed to manage the nation's money supply in proportion to economic growth, ensuring that inflation remains within the Goldilocks zone and unemployment stays low, without pushing up inflation beyond the nonaccelerating inflation rate of unemployment (NAIRU). Supply and demand principles also play a role in how businesses are impacted by inflation, for example, through rising costs of raw materials, higher interest rates, and changing employment rates, all of which may affect how businesses decide to price their products.
In addition to the known effects of inflation, supply and demand principles can also lead to unexpected outcomes. For instance, high inflation can reduce the overall demand for goods and services in an economy because they become more expensive, which in turn decreases the value of people's incomes. However, during times of rapidly rising inflation, customers may suddenly start stocking up on essential goods as they fear prices will continue to climb, leading to an unusual spike in demand.
In most cases, the best response for businesses to manage the effects of inflation in the long term is to focus on cost efficiency and productivity improvements.
Explaining the Impact of Inflation on Businesses
According to a survey conducted by the National Federation of Independent Businesses in February 2022, inflation was cited as the top concern for 26% of small business owners. This is a sharp increase compared to the 2% who named inflation as their biggest problem in the previous year's survey. The rise in inflation is attributed to the reopening of the economy after months of pandemic-induced shutdowns, leading to a situation where there was too much money chasing too few goods.
Inflation is expected to remain high for the foreseeable future, and businesses need to adapt to the changing economic environment. However, the impact of inflation on businesses is not uniform across all sectors.
Essential goods and services are less affected by inflation, as demand for these items remains relatively constant regardless of price fluctuations. For example, workers who require gasoline to commute to work are more likely to reduce spending on non-essential items rather than let their tanks run empty. Businesses providing essential goods and services, such as grocery stores, healthcare providers, and tax professionals, are therefore considered recession-proof.
Similarly, businesses with a strong brand presence and customer loyalty tend to be less affected by inflation. Customers are more likely to stick with brands they trust even if prices increase proportionally across the market. However, supply chain disruptions or unavailability of certain products can cause customers to switch brands.
Finally, markets with few sellers are less impacted by inflation, as customers have limited alternatives to switch to. This is particularly true for businesses that rely on a single supplier, as they may be forced to pay higher prices for goods unless they can diversify their supply chain.
In summary, while inflation has a significant impact on businesses, its effect varies by sector and other factors such as brand loyalty and supply chain availability. Therefore, businesses need to assess their specific situation and adapt accordingly to mitigate the impact of inflation.
How Businesses Can Prepare
Although economists believe that the high inflation rates of the early 2020s will be transitory, it is unlikely to disappear anytime soon. The Federal Reserve Bank of Philadelphia's survey of 36 professional economic forecasters during the first quarter of 2022 estimated that the Consumer Price Index (CPI) would average 5.5% in that quarter. Additionally, they predicted that the long-term inflation rate from 2022 to 2031 would be 2.5%, which is 25% higher than the Fed's 2% target. Therefore, businesses need to be ready for further inflation.
One way for businesses to prepare for inflation is to raise their prices gradually over time. If competitors' prices are significantly higher, increasing your prices may not drive customers away, especially for essential goods. However, it is essential to stay competitive and not fall behind with price increases. Restructuring the workforce may also be necessary as costs rise. A well-thought-out restructuring plan can improve workforce productivity, increase employee loyalty and upskill the workforce. Additionally, offering incentives for advancement can help retain top-performing employees and attract skilled workers from other firms.
Reevaluating the product portfolio can also help businesses maintain their margins during inflation. Identifying low-profit-margin products and retiring them from the portfolio can allow businesses to focus on higher-profit items. Borrowing money at fixed interest rates early in an inflationary cycle can also be advantageous, as the cost of that borrowing will diminish over time, giving the business a competitive edge.
Diversifying suppliers and limiting just-in-time supply chains can also help businesses prepare for inflation. Relying on only one supplier can lead to problems when prices rise or when the supplier experiences problems or delays. Having multiple sources can give businesses more options and bargaining power. Similarly, maintaining a surplus of inventory on hand can help prepare for increased demand and supply issue delays.
Finally, businesses can examine where their costs are highest and use inflationary periods as an opportunity to reevaluate their spending. By implementing cost-reduction measures, businesses can maintain their margins during inflation.