Most of the people running companies, projects, and investments in the developed economies around the world have no practical experience of dealing with inflation. The last widespread outbreak was forty years ago. However, inflation is the key shadow facing global economies. (Yes, there are other shadows facing the world, like the terrible situation with Russia and Ukraine, but the key, global economic threat is inflation.)
How bad is it?
Very bad! The USA and UK have inflation rates of 9% and the Eurozone has inflation at about 8%. The trend in most regions of the world is upwards. Governments are starting to try to slow down the rate of increase in inflation (for example, by increasing interest rates), but I think they are doing too little, too slowly.
What is so bad about inflation?
The key problems with inflation are:
- It reduces purchasing power. If prices go up by 10%, then consumers can only by 90% as much stuff for the same amount of money.
- It feeds into higher costs. In inflationary times, workers need to increase their salaries, imports cost more, energy costs more, and borrowing money costs more. These increases, of course, help fuel further inflation.
- It makes everything more volatile. In inflationary times it is harder to negotiate a three-year deal with a client or supplier. Your input prices can go up multiple times in a year. Employees will seek to increase their salaries by what they expect inflation to be, or they will switch to employers who will pay them more.
- Exchange rates between countries become more volatile. This makes it harder to buy products and services internationally, and it makes it harder to sell and deliver international projects.
- It usually makes society less equal. People on lower incomes spend a higher percentage of their income on essentials than do people on higher incomes – so they have to cut back on essentials if incomes do not increase with inflation. People on benefits are particularly likely to see the purchasing power of their incomes fall faster than people in full-time employment.
- Interest rates go up, so interest repayments become much higher.
- Inflation and governments attempts to control inflation can spark a recession.
What can Governments do?
Governments have a range of tools, such as interest rates, the money supply, taxation and direct spending. However, all of these tools work in broadly the same way. To reduce inflation the Government seeks to slow the economy down. It needs fewer things to be bought and sold in order for inflation to fall. For citizens and companies that is clearly uncomfortable news.
The equation MV = PT helps understand the situation. MV and PT are both measures of the economy. P in PT is the level of prices. Inflation is when P is increasing. T represents the number of transactions, M is the quantity of money and V is the speed it is flowing round the economy. If the government can reduce M, V or T it will help deal with P. But reducing one or more of M, V and T means slowing the economy down.
Governments facing and election seem reluctant at the moment to increase interest rates by enough, and most of them are not even considering tax increases or cuts in spending.
Governments are also going to suffer from inflation. During the pandemic governments borrowed massively and the cost of that borrowing will soar under inflation. In terms of benefits and entitlements (such as pensions) the Government can either increase them by the level of inflation and hurt the public purse, or it increases them by less than inflation and hurts people.
What should you be doing?
- Expect your input prices to increase. I would currently assume that they will increase by around 10% this year, next year and the year after (but it may turn out to be better or worse than that).
- Put yourself in a position where you can increase your prices, at least annually.
- Do what you can to manage your interest repayments.
- Get your ship ready for turbulent times.
- Find out which items are going to do well during the inflation – there are always some items that do well. For example, economists usually predict healthcare, consumer staples, energy and real estate will do well during inflation. But so do some luxury sectors.
What causes inflation?
Unless you are an academic or in government, don’t worry about this. There are as many theories as there are economists. For those of us in business, the key is to cope with inflationary times, not to try and cure them.
Among reasons that are currently popular
- The energy crisis created by Russia and compounded by a lack of friendly interventions from OPEC.
- The extra spending by governments as they tackled the COVID pandemic. Governments borrowed and printed money and that money either creates inflation by increasing demand or it creates it via the MV=PT formular (increase M, keep V and T constant and P has to increase).
- Consumers built up savings during the lockdown and they are now fuelling inflation by spending some of their savings.
- Excessive profit making by key organisations – including the energy companies. Bloomberg reported in March that US big business had it biggest increase in earning for 50 years.
Note, I am not a financial adviser and nothing in this post should be construed as financial or investment advice.