Everything You Ever Wanted to Know About Inflation (Including How to Handle It)

Inflation anxiety is clearly setting in as the government data released in recent weeks indicates that U.S. inflation is the highest it has been in 13 years. With all this news fueling an inflation panic, it is important for businesses to make sense of this complicated topic.

Here are six questions to understand first before you make any business decisions in an uncertain pricing environment, as well as a game plan for how to act.

Contrary to popular belief, rising prices are a consequence of, and not the definition, inflation. Inflation is a process that leads to higher prices, but inflation itself is not singularly higher prices. Inflation is the decline of purchasing power in an economy; meaning when inflation occurs, you can’t buy as much with the same dollar that you could before. Thus, there are two sides to it. On the one side, we have the price of goods and services, and on the other, the value of the dollar.  Changes that affect either side can therefore lead to inflationary pressure.

Inflation can be caused by a variety of interrelated changes in the economy. One is an increase in the amount of money in the system (money supply). While it is not typically the way it is executed, you can think about it as the government printing money. When the government prints more money, if the increased amount of money chases around about the same amount of goods and services to purchase, the prices of these goods and services are likely to increase. A currency devaluation itself can also lead to inflation. As the dollar loses value, for instance, the same dollar can buy less of any good or service. Inflation can also be caused by direct supply and demand for goods and services. So, if anything disrupts the supply (production) of goods like the shutdown of global supply chains, for instance, inflation can result. Similarly, inflation can also result if the demand for goods and services outpaces the supply. As you can see, changes on either side of the purchase (money or goods), can lead to inflation. 

In our current case, inflationary pressure is likely being caused by a confluence of several factors. For one, as the economy recovers from the pandemic, demand increases are putting upward pressure on prices. Massive government relief for both individuals and companies have also pumped a large amount of money into the system. Commodity prices are also increasing due to the supply chain disruptions of the pandemic. Finally, companies are dealing with increasing labor costs, as the U.S. simultaneously deals with a hiring crisis. As a result, companies like Coca-Cola and Kimberly- Clarke are planning price increases to compensate for increasing input prices.

Inflation isn’t always bad. For instance, a modest rise in prices is also an indication of increasing demand for goods and services, so economies may benefit from a little inflation. When it starts becoming an impediment is when prices increase so much or the currency is so significantly devalued that consumers and producers find it difficult to purchase the goods and services they need. This could also lead to a decrease in demand that can slow an economy. Furthermore, as with most economic problems, there exists a strong negative feedback of inflation, such that once inflation accelerates it can be destabilizing to the economy and difficult to curtail. When consumers and producers expect inflation, for instance, they may purchase more today. Cue the hoarding of basic goods and services and the subsequent increased upward pressure on prices as demand increases.

While certain measures show inflation at a 13-year high, you should remember that inflation is commonly measured as a year-to-year change. Thus, much of the inflation we are measuring is a comparison of a baseline number from the height of the pandemic last summer when the global economy was, well, out of whack. When instead of comparing to pre-pandemic levels, inflation is essentially half of what is being reported. Measures comparing prices now to last year, therefore, should be viewed with caution.

If there seems to be sustained inflation, the government could intervene in several ways. As one of the causes of inflation is increases in the money supply, the government could counter inflation by decreasing the money supply. One method that the government can implement this is by increasing interest rates.  By making loans more expensive, the amount of money in the system decreases as consumers and companies have less money available from loans to buy goods and services. In addition, increasing interest rates make saving relatively more attractive to spending, so people spend less. To dampen inflation, the government can also increase taxes and decrease spending, decreasing demand-side pressure in the economy.   

First, don’t panic–plan. Here are five suggestions:

Acting quickly and with large amounts of money can contribute to the negative feedback loop mentioned earlier that the economy can experience. Furthermore, inflation indicators are being measured off a very strange, (hopefully) one-off period in our economy. As a result, while the effects may take a little while to dissipate, they are likely transitory. Furthermore, the government has many tools at its disposal to curb inflation. Thus, expensive, and irreversible decisions made as a function of the inflation news should be made with great care. 

2. Spend now if you were already considering large purchases of capital equipment. If these purchases make sense for your business, buy sooner than later as prices may continue to increase and loans for equipment may become more expensive.  Furthermore, if the government uses increased taxes to dampen demand, businesses may have less available cash in the future. 

3. Secure that fixed interest loan now if you were considering a loan. 

Rising interest rates in the coming months may make the same loan more expensive in the future. Use the loan to build up inventory to mitigate the impact of rising prices of inputs.

4. Increase prices slowly.

If your production costs or demand for your product is increasing, slowly increase prices now thereby avoiding big jumps in the future that could deter consumers. Couple the price increases with product redesign and reformulation in a way that adds value to the consumers, for instance, making packaging more environmentally friendly.