One of the key issues facing the global economy right now is the extent to which present inflation is a temporary consequence of supply chain disruptions, or the long awaited consequence of more than a decade of emergency monetary policy. Regardless of the proximate or underlying cause, the data is clear: inflation is high and rising:
This is important. Central bank competence rests on their credibility - i.e. do the public believe that they will achieve their stated objectives? And I think we can split credibility into two elements:
Their capability to fight inflation. Since the global financial crisis central banks have obtained a whole suite of new tools to conduct monetary policy in different ways. For example, a “corridor system” uses three different interest rates to guide policy and was introduced in large part to mitigate the risks of QE.
Their commitment to fighting inflation. Historically the Fed in particular have been behind the curve in responding to fast changing macroeconomic conditions. Now that the Fed and the ECB have greater room to permit inflation to go above target, it becomes less certain that they will act early and decisively to quaff it.
Personally, I am confident that central banks have the tools to prevent inflation getting out of control, but I have more doubts about their commitment. It’s therefore worth considering how to proceed if inflation continues to rise.
The purpose of this post is to consider some of the implications for managers.
How to deal with inflation: revenues
The obvious response to how managers should respond to inflation is to raise their prices. But of course that is what inflation is. It’s not a plan.
One option is to follow the lead of the Japanese ice cream company who, in 2016, released this video to apologise to their customers for having to raise the price from 60 to 70 Yen (see here for more):
But don’t forget that there are alternatives to raising prices. Akagi Nyugyo could have:
Reduced the amount of ice cream contained in a serving
Used lower quality ingredients
So firms need to make adjustments to their products and their pricing.
Inflation also poses a much deeper problem. If the economy were always in equilibrium, inflation wouldn’t matter. Higher total spending would cause all prices to move instantaneously, and relative prices wouldn’t change. In the real world, however, problems occur because some prices rise faster than others. Typically, revenues are more flexible than costs, and therefore inflation boosts profits and encourages (unsustainable) expansion.
Inflation therefore poses a real problem to entrepreneurs. They have to solve “the signal extraction problem”, which asks the following question: “what proportion of any increase in demand for your products is due to consumers placing a higher value on them, and what proportion is due to inflation?” It’s an impossible question to answer, but an important one to ask. How much of your profitability should you attribute to successful entrepreneurial activity, and how much is a reflection of wider macro events?
How to deal with inflation: costs
The main justification for positive inflation targets rests on that fact that wages (i.e. the “price” of labour) are particularly slow to adjust. Few people want their wages to perfectly track economic conditions, because we like to have some financial stability. Many people’s salary is only adjusted once a year, and labour markets are therefore much slower to adjust than things like commodities or share prices. This generates a macroeconomic problem, however, because the labour market is so important. One way to enable people’s real wage (their actual purchasing power) to adjust, without relying on firms to change their nominal wage, is through inflation. If central banks engineer system wide positive and moderate inflation (e.g. 2%) then employers can reduce their (real) costs without having to reduce anyone’s pay packet. So it is important to be careful with automated cost of living adjustments. If your business has consistent performance, and you want to ensure that your employees receive the same actual compensation, you must increase their nominal payslip in line with inflation. (But don’t forget that the signal extraction problem is boosting profit and thus overstates performance). For companies that are struggling right now, and need to cut costs, inflation provides scope to do so. Afterall, it isn’t corporations who cause inflation, it is central banks. Central banks are the one to blame.
That said, we are still in competitive labour markets and across the board wage freezes are a terrible strategy for your high productivity employees. So I was particularly interested to see Lance Wigg’s advice on coping with inflation:
Invest more time in benchmarking salaries and recognise these need to be updated more frequently
Early career employee’s market value will change more quickly than others, so they need more frequent reviews
If you are worried about losing talent don’t be afraid of paying more than the market, and then allowing inflation to catch up later
Looking beyond labour markets, his further advice includes:
Buy expensive items earlier in the cycle than you were previously planning
Minimise cash holdings
Move toward index linked debt
Finally, inflation is very tough on groups that have fixed incomes and (often) lower salaries. As a society we should recognise these costs of inflation and hold central banks to their mandate of protecting us from it.