Shoring up Businesses in the Face of Inflationary Pressures
Annual inflation hit its highest point in twenty years in November 2021, with consumer prices up 5.3% year-on-year. EY reckon this trend could be lasting, with inflation expected to average 3.3% next year. Considering the EU target inflation rate of 2%, the severity of these figures is clear. Similar statistics are seen internationally, with the European Central Bank (ECB), Federal Reserve (Fed) and Bank of England all preparing to quash inflationary pressures over the coming months. For example, the Bank of England recently announced increased interest rates to 0.25% , the Fed has signalled to end their bond purchases (heightened during the Pandemic) in March and plan to enact three interest rate rises during 2022. In a differing response, the ECB will continue bond purchases for at least 10 months, before scaling back the procedure. They also ruled out raising interest rates next year, illustrating the ECB’s viewpoint that inflation should fall in 2022. With these actions taken by various central banks in mind, businesses ought to prepare to minimise the potential costs of inflation.
Reasons Behind the Rise
McVities’ recent announcement that some family favourites such as Hobnobs, Jaffa Cakes and Penguins could see price increases of up to 5% illustrates the direct impact of these inflationary pressures on consumers’ pockets. The UK Managing Director at Pladis Global, owner of McVities, attributed this to Covid-induced staff absences and the rise in input costs, with double digit percentage increases on ingredients such as cocoa beans, alongside higher labour costs.
The vaccine rollout and the economic recovery is also releasing pent-up demand from the pandemic, causing demand to outstrip supply in the economy and prices to rise; this is also known as demand-pull inflation. Another view, as McVities shows, suggests that weakened supply due to labour shortages, aggravated by Covid-19 induced absenteeism and the new Omicron variant, could be driving inflation. Other supply-side issues include the rising costs of core ingredients, perhaps due to supply chain disruption (as a result of the pandemic). This is known as that cost-push inflation, whereby an increase in the costs of wages and raw materials is passed onto consumers in the form of higher prices, is boosting inflationary pressures even further. The rise in inflation can be viewed from both the demand and supply-sides, illustrating its pervasiveness.
Costs of Inflationary Pressures on Firms
Rising costs due to inflationary pressures means rising uncertainty amidst a backdrop of an already unstable trading environment. This means that firms are less likely to invest in research and development, alongside technological changes for longer term production, hence negatively impacting long run growth rates. Furthermore, the impact on profit margins is ambiguous, and dependent on whether firms will be able to pass higher input costs on to consumers. The more price elastic a good/service is (i.e. if consumers reduce their demand a lot, given a small price increase), then the less likely a firm will be able to pass their rise in costs onto consumers. In this event therefore, profit margins for businesses are likely to fall, a clear cost of inflation on business owners. Additionally, the current business environment, with large staff shortages and absenteeism, means employees have stronger negotiating power regarding their wages. Therefore, despite both the Bank of England and the ECB suggesting there is little current risk of a wage price spiral, labour costs for firms could rise, thus aggravating this fall in profit margins. Ultimately, the costs for firms encompasses the uncertainty of the trading environment, and the resulting impact on long-term growth, alongside the potential fall in profit margins – the extent of which is dependent on the price sensitivity of their consumers.
Shoring up Businesses
With inflation clearly upon us, it is vital for firms to be aware of their business’ sensitivity to price changes. Despite being a challenge to accurately calculate, awareness of a products’ price elasticity, alongside forecasted and current inflation means that firms can be better placed to react to any price changes and minimise the impact on profit margins. Additionally, awareness of competitors can also help firms respond to rising inflation; if the competition raises their prices, it becomes easier for smaller firms to increase their prices without losing too much demand. Thus, awareness of the competition’s actions, alongside a focus on the business’ unique selling point to make it stand out from the competition, are vital to reduce the impact of inflation. With much of inflation because caused by shortages on the supply side, international diversification can reduce supply chain risk and diminish the impact of rising costs. Indeed, the evaluation of supply chain risk alone, alongside analysing the necessary responses to these risks, can help prepare firms, enabling them to better respond to crises once they arise.
Furthermore, issuing debt can allow firms to diversify their financial portfolios in a way that reduces the impact of rising prices. Since inflation erodes the real value of money, businesses ought to reduce their cash holdings and instead buying capital assets or equipment that promote long-term growth and help businesses ride through the uncertainty. The ability to take out a loan to fund these investments depends on interest rates. Despite the Bank of England’s announced rise in interest rates to combat inflation, rates still remain low; the ECB, for instance, has thus far decided to keep rates at their low. Hence, as long as rates do not rise further to combat the inflation, businesses will be able to pay back their loan cheaper relative to what they borrowed it at. If this loan is used to promote long-run growth through solid investments, then businesses could use inflationary pressures to their favour. Furthermore, stockpiles could be used as long-term buffers, better preparing firms for the rise in inflation. Additional long-term buffers could be sought through locking-in long term contracts at current prices – taking advantage of futures markets to reduce the costs of inflationary pressures.
Ultimately, for businesses to respond well to the current pandemic-induced inflation pressures, forecasting and preparing for all scenarios, alongside acknowledging their competition, price sensitivity, and reassessing their investments is crucial to shore themselves up against rising prices.