In a closed system economy, inflation is the measure of the rate of rising prices of goods & commodities, as well as services. When there is inflation prices of basic necessities such as food, gas and healthcare tend to go up because often the process to produce them are intertwined at the industrial level – this can dramatically impact society and may even cause an economic recession.
Inflation affects everything that can be sold, purchased or traded. Whether it’s need-based expenses such as housing, food, medical care, and utilities, as well as want expenses, such as cosmetics, automobiles, and jewelry. Almost nothing is spared from this negative economic phenomenon. Inflation normally lasts between 1 – 3 years, however, the 1933 economic recession has shown us that its effects can last for about a decade and unless something drastic happens (like WWII that has boost the industrial sector of the United States which inadvertently revived the US economy), then the country/countries hit by inflation will inevitably become a failed state.
It is the job of each country’s central bank to monitor the economy to watch signs for weaknesses, predict and warn the government and the public of an impending inflation, so that both the government and its citizens can come up with a plan to avoid inflation. In the United Kingdom The Bank of England is the government arm responsible for creating strategies and contingency plans to avoid inflation. Typically, the Bank of England’s inflation target is approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.
The biggest problem with inflation is that it devaluates the British Pound (or any other currency for that matter) and the savings you have in your bank account that’s worth £10,000 today, will lose between 1 – 30% of its value overnight when inflation hits! Inflation erodes a consumer’s purchasing power and even has the power to mess up with your retirement benefits. For example, if a hedge fund investor made 5% profits in capital gains, but the inflation rate is 3%, then it will be adjusted accordingly and his only real earnings are 2% nominal rate. In this article, we’ll examine the fundamental factors behind inflation, different types of inflation, and how it affects manufacturers and consumers.
Inflation in the US started about 4 months since President Joe Biden took office and then with the war in Ukraine things went out of control with the sanctions on Russia having a negative effect on the European economy as well – even us over here in the UK are feeling the sting of inflation. Both small and large manufacturers alike are being affected by inflationary pressures in the same way more or less, although it is the small manufacturers that are hit the hardest.
These pressures are being further exacerbated by:
- The speculation around a possible recession hitting between now and Q4 of 2023
- All-time record low small business expectations being reported
- The lowest consumer economic expectations being reported since 1980
Knowing that a recession is on its way is not quite reassuring, because we don’t know when, why, or how it might happen. However, factoring in small businesses getting squashed and consumer confidence diminishing, the fear of another recession will only make things worse, especially for the manufacturers. Things like rising costs, botched contracts, labor shifts, and input issues, will inevitably affect inventory and capital purchases.
Table of Contents
- The Pressure of Rising Inflation
- Costs
- Contracts
- Labor
- Inputs
- The Effects Of Inflation On The Distribution Business
- How Inflation Affects Consumers
- Consumer Goods
- Savings Accounts
- Investments
- It Hurts the Poor Disproportionately
- Inflation Raises Interest Rates
- It Lowers Debt Service Costs
- It Can Cause Painful Recessions
The Pressures of Rising Inflation
Costs
Inflation causes cost of goods and services to rise faster than manufacturers can keep up with adjusting the pricing of their products to get a return. This is even more difficult for industries with tighter margins. Manufacturers will determine their pricing structure depending on how much of the sting of rising inflation they will feel. Unfortunately, some manufacturers will likely be disproportionately affected, especially the ones who use cost-based pricing, because during inflation cost can rise rapidly and very quickly. Sooner or later they won’t be able to increase their prices enough to even breakeven.
This will lead to their margins shrinking and they’ll have to figure out a plan to acquire cheaper raw materials, but obviously that’s nearly impossible under an atmosphere of inflation. When push comes to shove, manufacturers in such dire circumstances must have smart leaders who has the foresight on making the best decisions regarding their pricing. If they made the right call, then they will have successfully protected their shrinking margins while remaining competitive.
On the other hand, manufacturers can slow down mass production rates to balance out the supply and demand equation, as obviously when inflation hits the supply chains becomes limited. They can still maintain the current pricing on their products without suffering a deficit in sales. This manufacturing tactic can already be seen in packaged goods and it is likely to continue for the foreseeable future.
Contracts
The reason why the media is reporting a supply chain crisis in the United States (and elsewhere) is due to the fact that PPI (Producer Price Index) above 11%, while the CPI (Consumer Price Index) is only above 9% at the moment. This means that it costs more for producers to manufacture products than it cost consumers to purchase them. Under such conditions, large manufacturers may have a better odds at surviving the rising inflation than small and medium-sized manufacturers do. The reason is because small and medium-sized manufacturers will most likely have contractual obligations with their suppliers that only adds to the problem they face regarding manufacturing costs.
Another cause for concern is when contracts expire and they need to renew them with their suppliers. While they may not be able to predict the cost increase due to rising inflation, they can be certain that the new pricing set by their suppliers will be shocking to say the least. But it’s doesn’t have to be all that scary because with the right leadership team in place, manufactures can negotiate a deal to have the suppliers reduce their pricing.
Manufacturers that sell components to larger manufacturers (as well as other small manufacturers) may not be in the position to negotiate the terms of their contracts, as they are likely selling at a locked in price. Being treated as a Tier 2 or Tier 3 supplier instead of a primary supplier gives them little-to-no leverage to ask for a higher price, in accordance to the rising inflation, for the raw materials they’re supplying big manufacturers. Another issue that these types of manufacturers have is that the processes of their production are heavily dependent on a labor workforce than the use of automation (which is costly and can be used as a justification for jacking up their price). In most cases, it is the large manufacturers that dictate the terms of their contracts with these types of manufacturers, and often the large manufacturers allows them to either let them break their contracts or renegotiate their contracts to keep them afloat. However, when renegotiation is unclear or outright not going to happen, then the CEOs and CFOs of these small manufacturers will have to work together and find ways to reduce manufacturing costs to avoid going bankrupt.
Labor
Manufacturers who will be the least affected by rising inflation are those that rely more on their capital and have a value-add component to their manufacturing processes, while those who rely on their labor workforce will feel the sting of inflation. It cost money to hire, train and put a labor force on the various areas of a manufacturer’s factory. It becomes even costlier now that we’re in a rising inflation, in fact, one could argue that the wage increases for a docile labor force that has no more skills to gain (even if training for new skills is on the table) is unfair or unrealistic (no offense to factory workers).
The reality of getting new skills in a mass production manufacturing plant is slim at best, because workers are trained only once to learn what they needed to do to keep the production line going non-stop. If there is new training needed for skills required to operate a machine, it is only relegated to a few employees and not all; however, wage increases are indeed necessary as it will hurt the employees as much as the manufacturer when their salary can no longer pay for rent or put food on the table.
This has resulted in CEOs seeking an alternative and less expensive labor force overseas, which made offshoring manufacturing operations a good idea from a financial standpoint for manufacturing companies. Additionally, automation and digitization technology have improved so much that taking labor out of the manufacturing process altogether will actually cut costs for the manufacturers than the opposite when compared to about just a decade ago.
Inputs
The overlapping cause and effect results with the war in Ukraine and sanctions on Russia has caused fuel sources such as petroleum, diesel, and natural gas to skyrocket plus the rising inflation put together just adds more pressure on manufacturers that rely heavily on these inputs for their processes. Unfortunately for manufacturers, they have no choice but to accept these cost hikes on the nose, as these inputs are irreplaceable; and even if they could find a different supplier for these inputs (and/or replace these inputs – *which is next to impossible), the price difference will make no difference because these things are controlled by OPEC (The Organization of the Petroleum Exporting Countries) and all pricing are the same across the board worldwide. Manufacturers should look to their accounting and finance teams to come up with contingency plans and other financial strategies to get the most out of these expenses to improve their bottom line.
The Effects Of Inflation On The Distribution Business
All companies operating in a close looped economy will suffer from the effects of rising inflation. There is no ifs or buts about it; however, when distribution companies adjust their pricing for inflation also, then that’s where the added pressure begins. Below are some of the effects of inflation on distributors and manufacturers.
- Decrease in customer purchases – A weakening fiat currency plus their savings money devalued, customers will instinctively go into thrifty mode and make lesser purchases than usual. This will also affect the profits for companies selling goods and services to consumers.
- Increased inventory costs – When it costs more to buy a new inventory than the profits you’ve made from the previous inventory, this will also create a shortage in profits which will hurt companies in the long run.
- Increased cost of service – There’s a cascading effect that happens to the pricing of goods and services when inflation hits, and the prices can only go up which is bad.
- Increased transportation costs – Inflation also affects fuel cost and vehicle maintenance, therefore adding more pressure on gross profit for companies.
- Wage factor – Inflation devaluates the fiat currency of all countries affected by it (and it almost always affects all nations on earth), it can therefore make employee wages inadequate on meeting their needs, affect productivity levels and increase personnel turnover. The effects of this can go far and wide in company operations which includes decreased throughput, delayed deliveries, and lower invoicing.
- Lesser loan approvals for investment or refinancing or business expansion.
How Inflation Affects Consumers
Consumer Goods
Inflation erodes the average person’s purchasing power. We all will feel the effects of inflation in varying degrees because we make different purchases on products and services. It’s hard to think that the prices for used cars and car rentals, furniture, airline fares, hotels and everyday essentials like groceries and gas go up during inflation, but that’s a given. According to the Bureau of Labor Statistics the Consumer Price Index (CPI) has gone up significantly across the board.
- Used cars is 29.7% higher this year than in 2021
- Clothing is 5.6% higher this year than in 2021
- Housing and remodeling supplies are also at an all time high since the 2008 recession
The reason why this is happening is because the value of your fiat cash is losing faster, while your salary remains the same, so a loaf of bread may cost $2.50 back in January 2022 now it cost $10! If you make $400 a week, you may want to hold off buying 10 loafs of bread a month like you used to. Unfortunately, your only options are to get more jobs, spend less or create more income streams, or do all of them at the same time.
Savings Accounts
According to Bankrate, the national average interest rate for savings accounts in the United States is 0.13% as of August 31, 2022 (1 year ago this figure was 0.06%). With rising inflation your savings will become worth even less as time goes by, unless the government will do something about it. But it’s still safe to keep your money in the bank, especially in emergency situations. It’s important to understand that a savings account or an emergency funds account is not designed to make you rich. No, if you want to get rich, then you invest in a hedge fund. A savings account is there to provide a financial cushion, should you need it.
You may also opt to buy physical material things that are worth hundreds or thousands of dollars, such as gold or silver jewelry. You can use them to pawn at the pawnshop in exchange for cash when times like this happens again – the inflation that is.
Investments
Due to the nature of the stock market, it would be near-impossible to predict how inflation will affect all of your investments, but one thing is certain – it will take away the value of long-term bonds, which is where your dividends come from. As inflation soars, your dividends’ value will go down. But having an investment is so much better than just a savings account because investment can generate returns in excess of inflation. The only downside to your investment is if the stock price of the company will plummet and the company will declare a Chapter 13 or otherwise known as bankruptcy. Just keep in mind to have a diversified portfolio of low-cost stock index funds and you’re in safe hands.
It Hurts the Poor Disproportionately
Low-income individuals, whether in the UK or elsewhere, would naturally spend a good measure of their income on basic necessities compared to the middle class citizens, and as a result will have nowhere to lean back on (e.g. savings account or emergency funds) once inflation hits and the public’s purchasing power gets diminished. This is what economists allude to when they talk about how lower incomes is associated with a greater tendency to consume.
Government officials and experts in the financial markets would pour out all of their effort on what they think is the core problem that causes inflation, and ignore food and energy prices. Unfortunately, food and energy have a higher volatility rate than other things that causes inflation and has a bigger impact in the longer-term inflation trend. However, they do not factor in the fact that low-income wage earners in developed economies and just about the entire population of developing economies spend a huge chunk of their money (usually wages earned each week or month) primarily on food and energy. These are commodities that are hard to replace and, in some unfortunate cases, people are forced to go without when the prices on these commodities sky rockets, as it is now evident in most European countries.
The majority of the lower class in the society also don’t own assets like real estate that they can depend on to shield themselves from rising inflation. On the other hand, those who are receiving basic state pension/workplace pension and the SIPP (401k social security benefits in the US) have some kind of protection against inflation, as their monthly remittances are adjusted based on an index of consumer prices.
Inflation Raises Interest Rates
Governments and central banks have much to gain when they keep inflation down. In the US, UK and around the world they implement a similar approach, which is to implement a specific monetary policy to manage inflation. Central banks in developed economies caps inflation at 2% normally (the cap in emerging economies on the other hand are at 3% – 4% respectively), but when these figures go up they automatically label the economy as under inflation and raise the minimum interest rate in order to dive up borrowing costs across the economy, and effectively limiting the money supply into the market.
This is why, if you notice, inflation and interest rates on loans go hand-in-hand in a troubled economy. By raising interest rates as inflation rises, central banks can dampen the economy’s animal spirits or risk appetite, and the attendant price pressures. You can expect the monthly payments for your yacht, or that corporate bond issue for a new expansion project to go up, because of the central bank’s default move during inflation. However, there are benefits and perks with increased interest rates, because that risk-free rate of return available for newly issued Treasury bonds will also go up, thus giving you more money for savings.
It Lowers Debt Service Costs
There’s no getting around the higher interest rates that lenders levy against new borrowers; however, those with fixed-rate mortgages and other loans may actually benefit from rising inflation. The money they’ll repay the lenders will be adjusted for inflation, which lowers debt service costs. So, for instance, you borrow £1,000 that has a 5% annual interest rate. If annual inflation subsequently rises to 10%, your loan balance which now has also been adjusted for inflation will decline annually and outweigh your interest costs. Keep in mind, however, that this scenario doesn’t apply to adjustable-rate mortgages, credit card balances, or home equity lines of credit, which under UK law allows lenders to increase their interest rate in order to keep up with rising inflation.
It Can Cause Painful Recessions
It’s only natural for governments and central banks to try their best to mitigate rising inflation and unemployment, but when inflation goes on for months, or God forbid, years just to protect jobs, then market predictions can cause investors to go on a panic mode and set off an inflationary spiral of price hikes and pay increases, which will lead to a recession. The United States alone has had over a dozen recession in its 200-year history, while here in the UK we’ve had 18. Recession causes mass layoffs, companies closing and wealth redistribution which is heavily lopsided to the wealthy elites and crushes the middle class and poor in society.
During rising inflation the government must get the best minds from all corners of the political arena, industrial and banking sectors to resolve it before it gets out of control. It’s not impossible as it has been done before. Hopefully this 2022 inflation will fade away and we return back to our normal lives to pre-COVID levels.
