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In the first quarter of 2021, gross domestic product (GDP) increased 6.4% year-over-year (yoy), signaling that the post-pandemic recovery is well underway. But not all economic news has been good over the last few weeks; the Consumer Price Index (CPI) rose 4.2% in April, its fastest increase in more than 12 years. The uptick led to fears that the economic recovery will be threatened by high inflation.
You may be wondering:
If we see rising prices, what will it mean for my business? And what are the chances that we see higher inflation?
To answer those questions, it is important to start by looking at a) what causes inflation to occur and b) what inflation means for the economy at large. Next, we will look at why our current recovery, in particular, comes with an increased risk for rising prices. Finally, we will explore what it all means for small business owners.
What Causes Inflation to Occur?
Broadly speaking, there are two drivers for rising prices in the economy: higher costs and higher demand.
If the cost of raw materials and/or labor goes up, businesses will pass on those higher costs to American consumers, resulting in higher inflation. In the event of a spike in demand, consumer confidence can lead to an increase in spending that exceeds businesses’ ability to raise production, again, resulting in higher inflation.
The Federal Reserve is, among other things, tasked with keeping inflation in check. The Fed typically uses the federal funds rate, which is the rate that depository institutions lend reserve balances to other depository institutions overnight, to achieve a balance between employment rates and inflation rates. That interest rate might not seem like a big deal at first glance, but it heavily impacts the interest rates charged for loans across the US economy. Since higher interest rates discourage consumption and investment and lower interest rates encourage consumption and investment, the Fed has a strong tool at its disposal.
With the federal funds rate near zero for much of the last decade, however, the Federal Reserve has tried to stimulate economic activity by using an unconventional form of monetary policy called quantitative easing. Through this policy, the Fed purchases longer-term securities from the open market, injecting money into the system. This activity doesn’t come without risk; the extra money artificially increases the demand for goods and services, which could result in higher prices. More on that in a bit.
What Does Higher Inflation Mean for the Economy at Large?
If the Fed is dovish (loose with monetary policy) for too long and the demand for labor, goods, and services exceeds the supply, we could see rising prices. Is that really so bad though? Wouldn’t everything just reach a new equilibrium? That would be nice, but unfortunately, it doesn’t work like that.
Let’s say the CPI shows that we are seeing 7% inflation. That doesn’t mean that the price of everything is increasing by exactly 7%. It means that, across the basket of goods and services that are being measured by the CPI, the average rate of inflation is 7%. Some goods and services will still see low inflation, while others will see prices rise at a double-digit rate. These distortions can have catastrophic consequences for business owners.
To continue with this example, say a business owner is forced to pay 20% more for labor and raw materials. But at the same time, its consumers only see their incomes rise by the headline inflation number. In this case, the business owner’s profit margins could plummet and they may even face bankruptcy.
That example doesn’t even factor in the big picture implications of inflation. In the event of rising prices, the purchasing power of the currency depreciates at a fast rate. Consumers respond by stocking up on household products. Businesses respond by making capital investments as soon as possible. These surges in demand – without an offsetting increase in supply – cause even higher inflation, leading to a disastrous feedback loop that rewards immediate consumption and penalizes long-term thinking.
There actually are winners when we see higher inflation – but, at the very least, there is always a loser for every winner. For those with debt, higher inflation allows them to pay off their loans with increasingly worthless dollars. But fixed-income investors get clobbered. In fact, just about everyone who signs a long-term contract at a fixed rate makes out when we see rising prices… but the counterparty sees an offsetting negative effect.
A number of economists would argue that inflation can increase the supply of labor. With wages increasing, the thinking goes, people are enticed to re-enter the workforce. That can happen… but only for a little while. If there is widespread inflation, it won’t be long until everyone realizes what’s happening. Unless companies are able to match workers’ expectations for inflation-adjusted salaries, any increase in labor supply will be short-lived.
Why Does the Post-Pandemic Recovery Come with the Risk of High Inflation?
The risk of rising prices is present in every recovery because higher demand leads to higher prices. But with the post-pandemic recovery, that risk is higher than usual.
Let’s start with the Federal Reserve, which is responsible for a lot of the inflation risk. In the 2010s, the Federal Reserve used the aforementioned quantitative easing policy to increase the money supply and spark growth. That policy didn’t have the intended effect, however, as commercial banks contracted their balance sheets at the same time, offsetting much of the quantitative easing. So, the quantity of money (M2) increased by just 5.8% per year from 2010-2019 and we saw low inflation throughout the decade.
To fight the economic downturn caused by the COVID-19 pandemic, the Fed again used quantitative easing. But this time, the Fed’s injection was amplified by the commercial banks. Between February 2020 and February 2021, the central bank injected $3 trillion into the economy, while the commercial banks added another $1 trillion. That combined $4 trillion works out to a 26% increase in the money supply – the biggest jump since World War II.
So, what will that actually mean for the economy? Well, China’s experience from 2009-2011 shows us what could happen. China increased its M2 by 23% a year in 2009 and 2010. The country achieved a strong recovery, but inflation jumped from minus 1.8% in July 2009 to 6.5% by July 2011. Yes, the US isn’t China and every recovery is unique, so there is no guarantee that we’ll go down the same road. But at the same time, it’s clear that a rapid increase in M2 comes with higher inflation risk.
On top of increasing the money supply, the Fed has pledged to keep the federal funds rate near zero for the foreseeable future, which, again, encourages consumption and investment. Which leads to price increases.
Joe Biden Spending Plans
Next, we have the spending plans that are coming from the White House. Joe Biden’s three big plans have a total price tag of $6 trillion. With Democratic policymakers controlling Congress, there is reason to believe that heavy government spending will continue for at least the next 2-4 years. To be fair, fiscal stimulus is necessary to help improve the economy over the next year, but the danger is that the government will overheat the economy, leading to higher inflation.
The events of the past year introduce further risk for inflation. Americans have been, for the most part, couped up in their houses since March 2020. When the economy fully reopens, people are going to want to go out… a lot. This pent-up demand can lead to price increases if the supply of goods and services is insufficient.
That supply may be insufficient for some time due to what’s happened over the past year, which brings higher inflation risk. That said, the supply shortages are likely to be short-term. This brings us to the reasons why inflation may not get out of control.
Inflation Might Not Be Too High in a Post-COVID World
Since the onset of the pandemic, two of the biggest stories have been supply chain disruptions and enhanced unemployment benefits. While those two things are currently creating inflationary pressure, they may not do so for long. Let’s look at them individually.
Over the past year, lockdowns and shutdowns have led to supply chain disruptions; labor, raw materials, and parts have been in short supply for countless companies. As a result, the prices of certain inputs have increased for companies, and they’ve been forced to pass on those higher costs to the end consumer.
There’s no telling when the frequency of supply chain disruptions will return to pre-pandemic levels. But it’s a good bet that it will happen over the next year, which will relieve inflationary pressure.
Enhanced Unemployment Benefits
For much of 2020, unemployed workers received a $600-a-week boost to benefits. With the normal benefits being too low for many Americans, the boost was designed to make up for any shortfall. The benefits have been reduced, but still stand at $300-a-week.
The benefits have offered a much-needed lifeline to millions of Americans, but in some cases, workers are making the same (or more) than they would from working. This, along with virus-related risk, has led to a shortage of workers in certain industries, putting upward pressure on wages.
But that pressure is likely to be temporary. The $300-a-week boost is set to expire in September. By the end of this year, the supply/demand for workers is likely to reach a better balance.
How Would Inflation Impact Small Businesses?
All things considered, it’s very possible that we will see rising prices. For that reason, you should be aware of the impacts that higher prices would have on small businesses – and be prepared.
The Cost of Borrowing Would Increase
In an inflationary environment, borrowers ask for higher interest rates to offset the declining purchasing power of the dollar. So, if you need to borrow money – whether it is to fund real estate or whatever else – it’s ideal to lock in a loan at a fixed interest rate before the market expects inflation. The key word is “expects.” If you wait until everyone thinks that inflation is coming, it’s already too late.
If you get a loan before lenders start expecting inflation, you could actually come out ahead in an inflationary environment. Let’s say you borrow money at a 3% interest rate. If we see 5% inflation over the next few years, which is very possible, the inflation rate would outpace your interest rate. By using a lending platform like Biz2Credit, you can ensure that you get the right loan before it’s too late.
Your Margins Would Be Impacted
The reason why inflation causes so many problems across the economy is that it causes distortions. You could potentially be forced to pay a lot more for labor, raw materials, and parts.
Here are some tips to mitigate those risks:
- Start giving your employees non-financial incentives to stick around. In the event of higher inflation, you might struggle to raise wages enough to offset their higher cost of living. But what you can do is make your company an excellent place to work. Consider offering more flexibility with time-off, career development opportunities, and a sense of community and purpose.
- Establish alternate supply chains. If you only have one supply chain and it experiences a bottleneck, you could be in trouble. By establishing alternate supply chains, though, you can have a backup that is ready to go if you hit any snags.
- Look into stocking up on supplies. While you don’t want to be filling plastic bags with gasoline, there are several supplies that can be stocked safely and inexpensively for a long time. By doing that, you will decrease the risk of the cost of a key part skyrocketing at the worst time.
- Evaluate all of your expenses and cut out the fat. By making your business lean and mean before we see rising prices, you can better position yourself to deal with a contraction in your margins.
- Consider the worst-case scenarios. What would do you if your supply chain was compromised? What if your employees demand a 25% raise and you can’t replace them? You don’t want to be caught off guard if these scenarios come to fruition. Instead, come up with contingency plans ahead of time.
Your Cash Would Rapidly Depreciate
It’s smart to have a lot of cash on hand to handle emergencies, but the value of cash rapidly depreciates in an inflationary environment. You should consider investing in assets that are expected to match, if not exceed, the rate of inflation. There are a number of possibilities including treasury inflation-protected securities (TIPS), fixed-income investments, and the stock market. Talk to a Certified Public Accountant (CPA) to learn more about your options.
Don’t Get Caught Off Guard by Inflation
After a brutal year, the American economy looks to have turned the corner. But all of the measures that were taken to prevent the economy from getting even worse during the pandemic came at the cost of higher inflation risk in the post-COVID recovery. It’s impossible to say if we will see higher inflation or, if we do, how much prices could increase.
But the risk of rising prices is present. And there are clear steps you can take to mitigate it.