When costs of a firm’s inputs of production rise, management can get worried about who bears this new cost and how to manage it. Inflation exists in every major economy - it is unavoidable. However, today’s firms have more opportunities than ever to hedge their operations against inflation and ensure maximum profitability, even in markets with significant price fluctuations.
Inflation, by definition, is the general increase of price levels in an economy. This, consequently, reduces the purchasing power of consumers (i.e. reduces the value of cash). Ultimately, there are 3 causes of inflation: the demand-pull effect, cost-push effect, and built-in inflation.
The Demand-Pull Effect
The demand-pull effect occurs when there’s an infusion of cash into an economy or a significant decrease in interest rates. This increase in income, both literally and synthetically, increases aggregate demand in an economy, which raises the average price level. Global governments shrunk interest rates and printed massive amounts of cash in the past year; according to the demand-pull effect, this will create inflation.
The Cost-Push Effect
The cost-push effect is the result of prices increasing throughout a supply chain. Instead of a firm incurring the cost, they either pass it on to the next firm in the supply chain or pass it onto the final consumer. This type of inflation can sometimes be isolated on a sector-by-sector basis. For example, increases in raw lumber materials will likely only affect industries which use lumber as a factor of production.
The Built-In Effect
The built-in effect is the final inflationary effect in an economy. With this effect, consumers expect inflation in the future. So, acting as rational agents, they hedge their wages against inflation by demanding higher wages now. This results in employers increasing wages, subsequently increasing their prices, driving market prices up, and eventually creating a circular engine of price increases.
How Inflation Affects Your Business
Now that we understand what inflation is and how it occurs, we can explore how inflation can affect your business. Inflation can be one of the most intense pressures that your business will face. In the 1980s, several canadian corporations were forced to close down when inflation rates reached over 12%. The gross price increases overwhelmed the companies and ate away at their margins. Without hedging their businesses against these pressures, business owners were left hopeless in the face of the bubbling environment.
To illustrate the risks of inflation, consider the following example:
An apartment developer is in the midst of building a large complex. They are running a pre-sale structure, where they are using deposits for units that haven’t been built yet to finance the construction. Buyers place their deposits on the units assuming the current lending environment would remain the same.
Unfortunately, inflation rates burst in the following year and the federal bank hiked interest rates to mitigate its effects and slow the market. This forced buyers to forego their down payments and left developers with massive amounts of inventory without any occupancy.
Since the developer didn’t have any contingencies or inflation hedges, the bank foreclosed on their development and they were forced to file for bankruptcy.
Although this type of inflation has not occurred over the last 30 years, it is still important to remember the damage that it can bring. Below are some strategies that you can use to hedge your organization against inflation:
- Do not hold onto irresponsible amounts of cash reserves.
- Use investment derivatives like options and futures contracts to lock in future prices, even if the market shifts.
- Consider purchasing office space rather than renting it, as real estate is a great inflation hedge. Or sign a long rental agreement for a fixed price.
- If you expect inflation is coming to your inputs of production, negotiate for contracts to lock in current market prices for your supply chain.
- Consider lean operations so that your margins can outpace inflation.
Inflation is one of the most studied topics in economics; however, there are only a couple of measures that are relevant to you when assessing the current inflationary market. When trying to assess aggregate inflation, we use the Consumer Price Index (see Figure 1) and the GDP Deflator.
The CPI is a market basket of goods and services that tracks the change in prices for an average consumer. The GDP deflator is used to essentially discount GDP, which provides us with the real rate of productivity increases in an economy. Finally, to assess individual markets, we use commodity indices to extrapolate price trends.
Inflation can obviously pose serious threats to businesses. Over the past 10 years, the Bank of Canada has done a great job in maintaining the inflation target rate of 2%. COVID, however, may bring a halt to this consistent inflation mitigation. As mentioned in previous posts, Canada has printed massive amounts of currency in the last year to provide economic stimulus.
Some estimates predict that Canadian inflation rates will exceed 4.5%. This can pose serious threats to margins and the economic viability of firms. We urge business decision makers to consider the threats that this poses to business and create a strategy to hedge against any inflationary pressures that may arise.
Throughout this article, we’ve covered what inflation is and how it can devalue the purchasing power of currencies. We then looked at how inflation can happen in three different ways: the demand-pull effect, the cost-push effect, and built-in inflation. Finally, we looked into how inflation can affect your business, the risks involved, and a few methods of protecting yourself against inflation.
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