How does inflation impact businesses?

In the UK, a new generation of managers may have little of their predecessors’ experience gained in the inflationary years of the 1970s and 1980s, when double-digit inflation persisted over several years. Some strategic and tactical skills may need to be relearned if inflationary pressures become embedded.

Inflation – problem or opportunity for business?

As recently as 2015, central banks were preoccupied not with inflation, but the prospect of deflation and falling prices. Deflation can be a big problem for consumer-facing businesses. Firms usually encourage consumers to buy now rather than delay until later, however deflation may encourage consumers to delay, in the expectation that prices will come down. Deflation also has implications for the value of firms’ stock holdings - they don’t want to be sitting on inventories that are going down in monetary value.

By contrast, modest inflation can be attractive to consumer goods companies. It encourages buyers to buy now rather than to delay. Inflation can help to mask changes in price positioning for a brand. If all competitors’ prices are static, it can be difficult to change prices without being noticed. If inflationary pressures force all companies to adjust prices, a structural price adjustment may go unnoticed.

Very high price inflation is a more serious concern to companies. It makes planning and investment decisions harder, and at a macro level, it may be associated with recessionary tendencies in an economy, leading to cutbacks in consumer spending. In extreme cases, high inflation can lead firms to hold onto their stocks longer, in the expectation that they will achieve higher prices tomorrow.

How to handle inflation

Businesses vary in the extent to which they can insulate their customers from the effects of cost-based inflation. Larger companies may hedge the cost of key inputs and may have resources to smooth out prices where input costs are cyclical. For smaller businesses without the buffer of financial resources, this may be more difficult, especially if their main input cost is scarce, skilled labour, which can command inflationary pay increases and cannot be stockpiled in advance.

Firms with strong brands generally try to maintain a constant base price for their key products, especially where consumers’ knowledge of prices is high. The “list price” may be a reference point for price positioning in comparison to competitors. If that list price was allowed to vary, consumers may pick up mixed messages about a brand, especially where price is an implied indicator of quality.

Tactically, there are many methods that consumer goods companies can use to manipulate prices without changing list prices. Discounts and special offers are cut back. In the current environment of supply chain disruptions, a short-term option is to manipulate the mix of products supplied, suspending formulations and sizes which are less profitable, and reducing supply to channels which achieve lower margins. Consumer goods companies sometimes reduce pack size (“shrinkflation”) rather than raise prices, on the basis that consumers are more likely to notice a price rise than a smaller pack size, especially for product categories where price knowledge is high.

Reading the market

In business, a single issue such as inflation can only rarely be seen in isolation from other issues. Inflation starts from somewhere, so if the source of inflationary pressures eases quickly, the problem of inflation may go away as quickly as it came. The problem this time is that many underlying and inter-related factors may be driving inflation. Supply chain bottlenecks may be a short-term problem which will soon be worked through. But costs involved in transforming to a zero-carbon economy (“greenflation”) and the lingering effects of large volumes of money created by quantitative easing - forcing up asset prices - may be harder to overcome.

Rising labour costs have been blamed on Brexit and COVID-19, but more serious inflationary pressure may come from falling birth-rates and increasingly elderly populations. In the short to medium term, a generation of baby boomers with generous pension savings may want to spend their money on services provided by younger employees, who will become more costly as most European countries experience falling birth rates. A higher ratio of dependant spenders to productive employees may put continuing pressure on prices. Faced with these seemingly intractable underlying problems, improving productivity is key to keeping inflation down, for nations and for individual firms.