What is inflation, and how does it affect your small business? In short, inflation reflects a reduction in the purchasing power of money – a loss of real value in the medium of exchange. In this article, we’ll explain what inflation is and how you can protect yourself from its effects. Let’s get started!
What is Economic Inflation?
Economic inflation is an increase in core prices and wages relative to a baseline level of prices and wages. The core inflation rate is the year-to-year change in the core index, which is calculated by the Bureau of Labor Statistics. This rate doesn’t include the volatile food and energy component prices so it tends to be a more accurate predictor of future inflation.
What Causes Inflation?
There are many causes of inflation and below we will be discussing four of the main ones:
Cost-Push Inflation
Cost-push inflation occurs when the prices of production inputs like raw materials and energy increase. Businesses begin raising prices to maintain profit margins, and this price hike gets passed on to consumers.
Demand-Pull Inflation
Demand-pull inflation happens when there is too much money chasing too few goods. It can be caused by rapid economic growth, an increase in government spending, or a decrease in taxes.
Supply-Side Inflation
Supply-side inflation happens when there is a decrease in the supply of money or an increase in the demand for money. It can be caused by a Central Bank setting interest rates higher or by people hoarding cash.
Asset-Price Inflation
This happens when the prices of stocks, bonds, real estate, and other financial assets increase. It’s often caused by easy credit conditions and can lead to an economic bubble.
How Does Inflation Affect The Economy?
It’s important to know what inflation is and how it affects the economy. Below, we will take a look at five leading economic inflation indicators:
Prices Rise
In general, prices rise when the demand for goods and services increases. Oil prices are a good example. When the global demand for oil increases, the oil and gas prices increase also.
Fuel inflation causes energy prices to increase resulting in the price changes of other goods and services increasing too.
These higher prices mean price increases to transport goods when fuel prices are high and there’s less price stability.
Interest Rates Rise
In order to curb inflation, the Federal Reserve (the central bank of the United States) will often raise rates of interest. Raising interest rates makes it more expensive for people and businesses to borrow money, which can lead to slower growth in the economy.
Stock Prices Fall
When inflation is on the rise, prices of stocks usually fall because investors are worried that the high prices will eat into corporate profits. They also believe that the Fed will raise interest rates to try to control inflation, making it more expensive for companies to borrow money and expand.
Dollar Loses Value
Inflation can cause the dollar to lose value because when prices go up, the purchasing power of the dollar goes down. And when the purchasing power of the dollar goes down, people are less likely to want to hold onto their dollars.
Wages Lag Behind Prices
Inflation can also cause wages to lag behind prices meaning that people’s incomes may not keep up with the rising cost of living. Thus, inflation can lead to a decrease in the standard of living.
- READ MORE: How to Protect Against Inflation in 2022
Measuring Inflation
The annual inflation rate is the percentage change in the price index from one year to the next. The economic growth rate is the percentage change in real GDP from one year to the next. Let’s take a look at the main ways inflation is measured:
The Consumer Price Index
The Consumer Price Index (CPI) is the most widely used measure of inflation. It measures the prices of a basket of goods and services that are bought by households. Central banks use the CPI to help them set interest rates.
The Producer Price Index
The Producer Price Index or PPI measures the prices that producers receive for their goods and services. It’s a leading indicator of inflation and can be used to predict changes in the CPI.
The Gross Domestic Product Deflator
The GDP deflator is a measure of the overall level of prices in the economy. It’s calculated as the ratio of nominal GDP to real GDP. The GDP deflator is a broad measure of inflation and is often used to compare inflation rates across countries.
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How Long Does Inflation Last?
Inflation can last for years, or it can be a short-term problem. The 1970s was a time of high inflation in the UK and worldwide. The reasons for this were an oil crisis and high government spending.
In the early 1990s, rising prices of oil and the reunification of Germany led to inflation in Europe. And in 2008, the global financial crisis led to a period of high inflation in some countries, particularly those with weak currencies.
READ MORE: Why is Inflation so High Right Now
How Small Business Owners Can Deal with Inflation
Economists are expecting consumer prices to hit 6.9% in 2022 on average. Long-term inflation expectations have an inflation target of 2.4% at some point in 2024. Here are five ways small business owners can deal with inflation:
- Review your pricing strategy. Regularly review your pricing strategy to ensure that your consumer prices are in line with the cost of goods and services. You may need to raise prices to cover the cost of consumer price inflation.
- Monitor your suppliers. Inflation can increase the cost of raw materials and other production costs. Monitor your supplier costs closely and be prepared to switch suppliers if necessary.
- Hedging against inflation. One way to protect your business from inflation is to hedge against it. This can be done through financial instruments like inflation-linked bonds or commodities.
- Increasing productivity. Another way to deal with inflation is to increase productivity. This can be done by investing in new technology or improving processes.
- Business Diversification. Diversifying your business can also help to protect against inflation and increase your business’ money supply. This can be done by expanding into new markets or products.
Inflation-Proofing Your Business Model
Inflation-proofing your business model involves strategic planning and adaptation to maintain resilience and competitiveness despite inflationary pressures. This proactive approach helps businesses manage rising costs, preserve profit margins, and ensure long-term sustainability.
Here are key strategies to inflation-proof your business model:
Expanding Income Streams
Expanding your revenue sources can buffer your business against the impact of inflation. Consider offering new products or services, exploring new markets, or adopting a subscription model for steady income. Diversification reduces reliance on a single revenue stream that may be vulnerable to inflationary trends.
Increase Operational Efficiency
Optimizing operations can lead to significant cost savings. Review your business processes for any inefficiencies and implement improvements. Automating repetitive tasks, streamlining supply chains, and reducing waste are effective ways to control costs and mitigate the effects of inflation.
Leverage Technology
Investing in technology can enhance efficiency and reduce costs in the long run. Digital tools and software can automate processes, improve inventory management, and facilitate remote work, which can lower overhead costs. E-commerce platforms can also open up new revenue opportunities and reduce the need for physical retail space.
Dynamic Pricing Strategies
Implementing dynamic pricing allows businesses to adjust prices in response to market demand and inflationary pressures. This strategy requires careful monitoring of costs, competitors’ pricing, and customer demand. Transparency with customers about pricing changes can help maintain trust and loyalty.
Build Strong Supplier Relationships
Negotiate favorable terms with suppliers, such as bulk purchasing discounts or longer payment terms, to reduce the impact of rising input costs. Establishing strong relationships and exploring alternative suppliers can provide more flexibility and bargaining power.
Focus on Value Addition
Enhancing the value of your offerings can justify price increases and maintain customer satisfaction. Quality improvements, additional features, or superior customer service can differentiate your business and support higher pricing in an inflationary environment.
Developing an Inflation Response Plan
An effective inflation response plan equips businesses to adapt swiftly to inflationary changes, protecting their operations and financial health. Here’s how to develop and implement a comprehensive plan:
Monitor Economic Indicators
Stay informed about inflation trends and economic forecasts. Monitor indicators such as the Consumer Price Index (CPI), Producer Price Index (PPI), and reports from central banks and financial institutions. This information will guide your strategic decisions and timing.
Review and Adjust Pricing Regularly
Create a policy for regular pricing reviews to ensure your prices reflect current costs and market conditions. Consider gradual adjustments to avoid customer shock and ensure your pricing strategy aligns with your value proposition.
Renegotiate Contracts and Terms
Proactively engage with suppliers, landlords, and service providers to renegotiate terms that consider inflationary pressures. Securing fixed-rate contracts or discounts can help manage costs more predictably.
Communicate Transparently
Maintain open communication channels with customers, employees, and stakeholders about inflation’s impact on your business and any necessary adjustments. Transparency fosters understanding, loyalty, and trust.
Build Financial Reserves
Strengthen your business’s financial position by building reserves to weather periods of high inflation. Effective cash flow management, reducing unnecessary expenses, and securing lines of credit can provide financial flexibility.
Train Your Team
Ensure your team is aware of the inflation response plan and their roles within it. Training on cost control measures, pricing adjustments, and customer communication can empower employees to contribute effectively to the plan’s implementation.
By inflation-proofing your business model and developing a comprehensive inflation response plan, you can navigate the challenges of inflation more effectively. These strategies enable businesses to adapt to changing economic conditions, protect their bottom line, and continue to grow despite inflationary pressures.
Planning Ahead and Taking The Positives
Planning ahead can help your business to survive and thrive during periods of high inflation. Here are five key takeaways inflation can be positive for your business:
| Beneficiary | Benefit of Inflation |
|---|---|
| Good for businesses | Inflation can be a sign of economic growth and can lead to increased demand for goods and services. |
| Can be good for debtors | Inflation can reduce the real value of debt and make it easier to repay. |
| Inflation can be good for savers | Inflation can increase the real value of savings and make them grow faster. |
| Really good for pensioners | Inflation can increase the real value of pensions allowing them to grow at a faster rate. |
| Great for businesses with fixed costs | Inflation can increase revenue and profit margins. |
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