What Could Inflation Mean for Your Small Business?
As of June 2021, the Consumer Price Index (CPI) one-year inflation rate was 5.4%, having risen from 4.5% in May and attained a new high since August 2008. The annual inflation rate last year in 2020 was 1.24%, and it is projected to grow to 2.26% in 2021 according to Statista.
Inflation is often talked about in terms of consumer prices, but its effects are often far-reaching, affecting business, investments, savings, and more.
Economists and the US Federal Reserve (the Fed) like to target 2% inflation annually as a measure of healthy Gross Domestic Product (GDP) growth. Since the current annual rate of inflation is much higher than that, we can very likely expect to see policy responses from the government and Federal Reserve in an effort to reduce it. When the Fed released its notes in August, it voted not to put in new policies, and said that it wouldn't touch interest rates for at least the next year. There's a lot of uncertainty as the economy recovers from COVID-19 (in addition to that associated with new possible variants), but we do currently find ourselves in an inflationary environment, and may be in one for at least the next year. Let’s take a moment to revisit what inflation is, explore its effects, and discuss what they could mean for your small business.
What is Inflation?
The inflation rate, which depicts a general rise or fall in prices of commodities over a given time, uses an index to track the change rate of prices for a set of select items in a “basket” of goods. The basket of goods is a collection of goods and services that are in the US economy. In other words, inflation rate is a measure of how much the prices of commodities, like food and gas, have changed. Inflation refers specifically to rising prices, while deflation is its opposite, referring to a drop in prices.
Inflation can be caused by several factors. However, in the modern day, the government generally follows a Keynesian approach to regulating the economy with monetary policy, which is where terms such as “printing money” and “raising interest rates” come from. Because of this approach, a major cause of inflation (or lack thereof) is usually economic policy. Inflation is also propelled by changes in production costs and/or demand for products and services. In this way, if, for example, demand for housing increases (like it did during the pandemic), the price of building materials will go up, resulting in inflation for raw goods like wood.
Production costs and wages can also be directly affected by economic policy decisions. For example, when local, state, and federal governments raise the required minimum wage, it usually results in inflation. This is because companies usually pass the added costs on to the consumer, resulting in higher prices for goods and services. Inflation is a normal part of a growing economy, and ideally, at least one of two things will happen alongside it: either wages will increase more than the inflation rate, or the cost of living will fall faster than the inflation rate increases (or both).
The inflation rate affects the purchasing power of consumers. Inflation isn’t just an increase in the price of a single product — the prices rise must be experienced across the basket of goods and services (ie, must be present in many categories). It's important to note that inflation is often a normal effect of economic growth. Even so, it does have an impact on prices and the cost of doing business, especially when the economy enters a state of higher inflation than the target 2% annual rate, or as a worst-case scenario, a state of hyperinflation (which the US is currently not in). Let's discuss the effects of inflation and the basics of what it means for business owners like you.
Inflation and Labor Costs
As discussed, inflation makes the cost of goods and services increase. This usually means that the cost of living goes up also (though not always). When people need more money to maintain their lifestyle, companies will usually increase wages. In fact, many companies have built in wage increases every year or few years that are intended to match the inflation rate.
Because the value of money goes down when inflation goes up, you will likely need to increase pay for your workers in order to remain a competitive employer (and to simply look out for your employees). If your labor costs go up, then that will likely result in you needing to raise your prices, which may result in fewer sales, and less cash flow. This presents a potential scenario that can be doubly challenging in which your business experiences less cash flow in, but higher costs to keep it running as usual. Whatever increased labor costs mean for your business, be prepared.
Labor Costs Action Items
- Assess your payroll and make sure that your salaries are competitive
- See how much your payroll costs will increase, and calculate how that will affect your profit margins
Inflation and Doing Business Internationally
Inflation and the cost of doing international business can get complicated, combining changes in currency value with the costs of goods and services. At a macroeconomic level, inflation devalues the US dollar and makes US exports cheaper. So, if you’re exporting internationally, it’s possible that your products will be cheaper than those of your competitors, and that your sales will increase. And, if we take the reverse, the cost of international goods will go up relative to the US dollar.
For example, say:
- 1 Euro = 1 US Dollar
If the US Dollar experienced an inflation rate of 2%, while the Euro stayed the same, then:
- 1 Euro = 1.02 US Dollar
International Business Action Items
- Assess how much your costs of doing international business have (or are projected to) go up
- See if you need to adjust your sourcing strategy
Inflation and the Cost of Borrowing
A short-term positive impact of inflation for those with outstanding loans is that the cost of borrowing goes down for existing debt (in other words, if you already owe money). This means that any existing loans you may have cost less to pay back in an inflationary environment.
Let’s say (as an example):
- 1 US Dollar in 2020 = 1 US Dollar in 2020
- 1 US Dollar in 2020 = 1.05 US Dollar in 2021
- 10,000 US Dollar loan in 2020 = 10,500 US Dollar loan in 2021
Or, put another way:
- 10,000 US Dollar loan in 2020 = 9,500 US Dollars in 2021
In a nutshell, inflation makes the cost of existing debt go down. This is great news for businesses who have taken out loans or other financing, though not as great for those that have operated on mostly a cash basis. Inflation isn’t great for savers or businesses with large cash reserves because it makes that cash worth less. This is why, when it comes to personal finance, many advisors recommend storing your money in liquid investment accounts that produce some return (usually at least 2%) instead of keeping all your savings in cash.
Lastly, note that one way the Fed regulates inflation is by raising interest rates through changes in the money supply. This means that once the Fed begins its policy response to inflation, any new debt that you take out will cost more to borrow in terms of payback amount. If you are looking to take out debt, think about trying to lock down an interest rate before the Fed raises rates. For products such as credit cards where the monthly APR is partially based on the prime rate (ie, the baseline interest rate as determined by the Fed), expect your interest rates to increase.
Borrowing Action Items
- Take out a business loan if you’ve been considering it. Since we’ll likely be in an inflationary environment for at least the short term, now is a good time to take out financing for your business, if you’ve been thinking about it. Should inflation continue at this rate for some time, the future cost of your loan will be lower than the ticket price.
- Think about your business’s portfolio strategy. If you have a lot of cash on hand, it could be time to switch to a more advanced capital strategy that looks closer to a personal retirement plan (but for your business).
Inflation and the Value of Commodities
In an inflationary environment, the cost of commodities goes up. This means that any raw material inputs will go up. Plus, since we’re all in the same inflationary boat, services are also likely to cost more as companies adjust their prices.
If you’re a business that deals mainly in commodities, like say, lumber, then your sales could see a dip. If consumer buying power can’t keep up with the increase in prices for your input, then although the inherent value of your commodity has remained stable, you’ll likely see less demand for it.
Zooming out, price increases at the commodity level have a ripple effect across supply chains, meaning that the cost of doing business goes up. For example, if you’re a contractor, then the cost of supplies go up under inflation, in addition to the cost to hire subcontractors (see previous section on labor), shipping, and more.
Commodity Business Action Items
- Prepare for lower sales. What will that look like, and how will you cope?
- Increase your pricing power. What value do your products bring to the end consumer? How can you keep sales up as prices increase?
Last Word: Money Costs Less, Commodities Cost More
Inflation can be a tricky subject that’s difficult to understand. The modern economy has a lot of moving parts, and so nailing down exactly what inflation could mean for your business can often be speculative. However, at its simplest level, inflation means this: borrowing money costs less, and the cost of doing business is higher.
If you have outstanding debt, then inflation is actually good for that: it means your debt now costs less to pay back. If you’re in a position to, think about paying back your loans a bit faster than you might otherwise while we’re still in an inflationary environment.
Our main takeaway is to be prepared for higher costs of doing business. Payroll, raw materials, and even services could all see an increase in price as higher costs get passed around. If consumer buying power doesn’t keep up with inflation (which it may not, at least temporarily), then think about what it might mean if your sales were to drop. Lastly, stay abreast of government and Federal Reserve policies. Since we’re currently seeing high inflation, we may be looking forward to higher interest rates in the future.