How Companies Can Prepare for a Long Run of High Inflation

How Companies Can Prepare for a Long Run of High Inflation

By Matt Dallisson, 08/05/2022

While consumers generally dislike inflation because it erodes the purchasing power of their income, businesses desire a steady level of inflation because investments made in today’s prices yield higher profits and returns in the future. Governments also like low and steady inflation. With inflation, government’s long-term borrowing needs to be repaid at a lower real cost, and a nation’s real income keeps increasing as long as employment remains high and the improvement in worker productivity exceeds their wage enhancements. Prices of assets such as houses and equities keep rising, attracting investors into the economy. The idea is that the economy keeps growing and everyone benefits.

So, why are consumers, businesses, governments, and investors particularly concerned about recent inflation news? What’s different this time?

Why inflation is so high right now

First, despite demand for goods and services reaching or even exceeding pre-pandemic levels, supply hasn’t caught up. Covid-related supply chain issues persist, with many goods remaining stuck in ships or ports. Shipping, freight, and insurance rates have skyrocketed to multiple times their pre-pandemic levels. China’s zero-covid policy comes with lockdowns and closures of the world’s most important manufacturing and shipping hubs. Many factories remain closed or have not resumed operations. Wages keep rising, and companies are still struggling to hire enough talent. A widespread shortage of truck drivers is affecting production chains.

Second, compounding those factors is Russia’s attack on Ukraine and the West’s subsequent sanctioning of Russian goods and trade. These developments have direct and indirect effects that fuel inflation. Russia is still an important supplier of oil, gas, and coal to European factories. Ukraine and Russia combined are the world’s largest exporters of grains, feed crops for cattle, and fertilizers for growing crops. Cutting off these supplies or even reducing them significantly throws a wrench in a well-functioning global supply chain system. Even if the war were to end tomorrow, sanctions and trade embargoes are unlikely to reverse soon and could take years (if not decades) to sort out.

The risks of protectionism

One likely outcome of these developments is that countries could turn protectionist, reversing decades of trade and specialization progress. For example, over the last 40 years or so, manufacturing moved away from the U.S. significantly. Meanwhile, California’s Silicon Valley became the global leader in new digital businesses ideas, Taiwan became the global supplier of semiconductors, and China’s Shenzhen region created an ecosystem for manufacturing electronic products. In addition, Brazil became the largest exporter of beef, China of steel, Canada of aluminium, Germany of cars, and the U.S. of radios and TVs and refined petroleum.

In other words, each region started specializing in producing goods in which it had comparative advantage or economies of scale. Goods crisscrossed the globe at various production stages before reaching customers. This specialization and trade lowered prices of goods and services and accelerated innovation. Just consider the price you recently paid for a large-screen LCD TV. You might find it to be lower than the inflation-adjusted price you paid for a small black-and-white TV in the 1990s. This was the outcome of well-functioning specialization and global trade. In other words, countries are better off specializing in a few things and trading the rest, instead of trying to be self-sufficient.

Now there is a real danger that at least some of that progress could be lost or reversed, forever. Countries may revert to more protectionist policies and attempt to become more self-reliant. Imagine a scenario where each country attempts to have its own steel mills, produces its own cars, runs its own airlines, and has its own oilfields and refineries. In addition, many countries would spend more on defense, which means fewer funds for real development. All of this would make goods and services more expensive.

What companies should do about inflation

We don’t think inflation will be coming down anytime soon, even while the Federal Reserve plans to reduce its balance sheet by more than $1 trillion this year (that is, mop up $1 trillion back from the economy, hoping that demand will reduce to become more in line with supply).

Given the new developments in Russia and Ukraine, the supply chain and inflationary issues have become far deeper and more prolonged than before. 

There’s no sugar-coating the fact that inflationary pressures and supply chain issues are real and here to stay. It’s important to develop an in-depth understanding of these problems and create a game plan to address these rapidly evolving challenges.

This content was originally published here.