Let's Talk About Inflation

June 6 inflation graphic

We’re all experiencing the impact of higher-than-normal inflation this year. In March, consumer prices were 8.5% higher than the year before (it’s about 7% in Europe and 7.5% in the UK). We see increased costs in the grocery aisles and the gas pump, smart people are predicting an economic recession on the horizon, and breathless news anchors are debating whose fault it is.

The April CPI report is due out this week, which will tell us a lot about where we are. Here’s my humble opinion (I’m not sure I would trust anyone who says they know for sure, one reason why economics is referred to as the dismal science): inflation will peak in the next one to three months and begin to abate in the Fall.

Consider three basic causes of inflation:

  • Cost-pushhigher prices of commodities (like oil) due to scarcity of supply, wages, and taxes, to name a few. Oil is a big one, not just for refined products like gasoline but also as a raw material. Ukraine is a major exporter of agricultural products, so the war there has created some scarcity.
  • Demand-pulltoo much money chasing too few goods; consumers willing to pay more for scarce goods or services. Remember, our economy went into recession in February 2020; unemployment was as high as 14.7% that April. In seeking to prop up our consumer spending during COVID (consumer spending is 70% of our Gross Domestic Product), our government provided $850 billion in direct payments, $800 billion in PPP loans, and other measures. In 2020 the Fed cut interest rates to near zero, stimulating investment which put a lot of money in consumers' pockets, and retail sales went from $5.6 trillion in 2020 to $6.6 trillion in 2021.
  • Monetary and/or fiscal policy the government printing more currency, issuing more debt, or easing interest rates. By December 2021 the money supply had increased by about 40%, but GDP grew only 5.7% in 2021. So the money supply has outstripped the growth of our economy. Nobel-winning economist Milton Friedman famously said: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Managed inflation is desirable. More money means more consumer spending, more spending leads to increases in prices and wages, and increased prices and wages lead to increased demand. So it can be a virtuous cycle, but not when it’s this high.

The problem leading to potential recession is that erosion of the value of dollar-denominated assets can begin, which causes a retreat in the financial markets and discourages future investment. If investment slows, production will slow, which impacts wages and profits. If wages and profits slow, then consumer spending retreats, impacting our GDP. What will the Fed do? I’m not sure, but probably continue to raise interest rates over time.

What does this mean for our businesses? A few things to keep in mind:

  1. The cost of credit will probably rise, so interest expenses are likely to be higher.
  2. Watch your sales pipeline and backlog and ensure you don’t get trapped with an inventory level that is mismatched to future demand.
  3. Don’t panic and start whacking costs indiscriminately. Instead, attack low value-added demand (too much space, investments whose business cases have changed) and then look to reduce unit costs. Work on the efficiency of back-office processes (create visibility of spending, and differentiate between strategic and non-strategic).

I’ll talk more about how we should think about responding next week.