How businesses can prepare for a long period of high inflation
Consumers, businesses, governments and investors are particularly concerned about the latest inflation news. With demand continuing to outstrip supply and Russia’s attack on Ukraine and subsequent Western sanctioning of Russian goods and trade, inflationary pressures and supply chain issues are real and here to stay. It is important to develop a thorough understanding of these issues and create an action plan to address these rapidly evolving challenges. The authors present seven new strategies for companies to fight against long-lasting inflation.
While consumers generally dislike inflation because it erodes the purchasing power of their incomes, businesses want a stable level of inflation because investments made in today’s prices generate profits and higher returns in the future. Governments also appreciate low and steady inflation. With inflation, long-term government borrowing must be repaid at a lower real cost, and a nation’s real income continues to rise as long as employment remains high and worker productivity improves. exceeds their salary increases. Asset prices such as homes and stocks continue to rise, drawing investors into the economy. The idea is that the economy continues to grow and everyone benefits.
So why are consumers, businesses, governments and investors particularly concerned about the latest inflation news? What’s different this time?
Why inflation is so high right now
First, although demand for goods and services is at or even above pre-pandemic levels, supply has not 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 several times their pre-pandemic levels. China’s zero covid policy comes with shutdowns and shutdowns of the world’s most important manufacturing and shipping hubs. Many factories remain closed or have not resumed operations. Salaries keep rising and companies are still struggling to hire enough talent. A widespread shortage of truck drivers is affecting production lines.
Second, Russia’s attack on Ukraine and subsequent Western sanctioning of Russian goods and trade compounds these factors. These developments have direct and indirect effects that fuel inflation. Russia is still a major supplier of oil, gas and coal for European factories. Ukraine and Russia combined are the world’s largest exporters of grain, fodder crops for livestock and fertilizers for growing crops. Cutting off these supplies or even drastically reducing them puts a damper on a well-functioning global supply chain system. Even if the war were to end tomorrow, the sanctions and trade embargoes are unlikely to reverse soon and could take years (or even decades) to settle.
The risks of protectionism
One likely outcome of these developments is that countries could turn protectionist, reversing decades of progress in trade and specialization. For example, over the past 40 years or so, manufacturing has moved significantly away from the United States. Meanwhile, California’s Silicon Valley has become the world leader in new digital business ideas, Taiwan has become the world’s supplier of semiconductors, and China’s Shenzhen region has created an ecosystem for electronics manufacturing. In addition, Brazil has become the largest exporter of beef, China of steel, Canada of aluminum, Germany of cars, and the United States of radios, televisions, and refined petroleum.
In other words, each region began to specialize in the production of goods for which it had a comparative advantage or economies of scale. Goods traveled the world in various stages of production before reaching customers. This specialization and trade have lowered the 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’s lower than the inflation-adjusted price you paid for a small black and white television in the 1990s. It was the result of specialization and global trade that worked good. In other words, countries would be better off specializing in a few areas and trading the rest, instead of trying to be self-sufficient.
Now, there is a real danger that at least some of this progress will be lost or reversed, forever. Countries can revert to more protectionist policies and attempt to become more self-sufficient. Imagine a scenario where each country tries to have its own steel mills, produces its own cars, runs its own airlines and owns its own oil fields and refineries. Moreover, many countries would spend more on defence, which means less money for actual development. All of this would make goods and services more expensive.
What companies should do in the face of inflation
We don’t think inflation will come down anytime soon, even though the Federal Reserve plans to shrink its balance sheet by more than $1 trillion this year (i.e. mop up $1 trillion from the economy, hoping that demand will reduce to become more in line with supply).
Previous HBR articles have offered valuable suggestions on how businesses should fight or plan for inflation. Given new developments in Russia and Ukraine, supply chain and inflationary issues have become much deeper and more protracted than before. Here are seven new strategies for businesses to fight longer-lasting inflation:
- Above all, understand your entire value chain and its exposure to supply chain shocks. In other words, go beyond just knowing your immediate supplier – identify the supplier behind your supplier, and so on. Even a minor sub-component criss-crosses the world in various stages of manufacture. Assess the risk of disruption at each stage, develop alternate sources of supply, and maintain sufficient inventory. Gone are the days of maintaining lean, just-in-time inventory.
- Understand your capital structure: your mix of stocks, preferred stock, bank loans, short-term credit, supplier credit, and convertible debt. See which ones need to be repaid and when, which ones are hit by interest rate increases, and which ones could hurt your business if you default. Financial plans that have worked for the past decade may be too risky for years to come. Restructure your loans, get new lines of credit, and maintain a sufficient cushion.
- Pay particular attention to global developments, realignment of country alliances and changing policies of international suppliers. These factors can no longer be taken for granted. You cannot expect countries to act rationally in their long-term economic interests. Politics, international pressures and national fervor could dominate rational economic thinking, driving rapid changes in trade policies.
- Pay attention to Fed policy announcements and meeting minutes. They often contain well-designed plans and policies that can surprise businesses when implemented. For example, each recent announcement of interest rate hikes has taken stock markets by surprise.
- A significant challenge amid the outflow of people from the labor market is keeping morale up and preventing attrition. The loss of a key employee means months of lost productivity and the expense of extra effort to find and train a replacement. Therefore, it is especially important to be in constant communication with employees and at least be aware of their job change plans. Be more flexible to accommodate their personal needs, such as letting them work from home, which can increase employee productivity.
- The luxury of pursuing non-remunerative ideas is now over. It is time to rationalize activities, customers, professions, brands, segments, suppliers, manufacturing sites, product lines, because short-term survival takes precedence over long-term growth. Go back to the drawing board to identify key areas and focus on those that offer the best returns for finite resources while also being the most promising for the future.
- A natural tendency in these times is to apply a universal ax and order a general reduction in wages, expenditures and manpower. An obvious result of such actions is low morale and further attrition of talented employees. It may also be tempting to start cutting forward-looking expenses such as R&D, employee training, and advertising. We strongly advise against such harsh actions. Use a finer scalpel instead. Design a new dashboard to rank activities and lines of business in terms of retention priorities. The scorecard should reflect current organizational priorities while allowing room for future growth and profitability. For example, it should include:
- Return on investment based on current market values of assets, instead of historical values
- The cash cycle – i.e. the time it takes from investing money in inventory to collecting money from the customer
- Risks and uncertainties, from supply to logistics and customers’ ability to pay
- Growth, a combination of total addressable market and achievable market share
There is no watering down that inflationary pressures and supply chain issues are real and here to stay. It is important to develop a thorough understanding of these issues and create a game plan to meet these rapidly changing challenges.