Updated: May 21, 2021
The recent release by the U.S. Bureau of Labor Statistics of the April CPI has revealed an alarming, but expected trend. Federal Reserve Chair Jerome Powell has made recent statements that the price increases we are seeing are transitory, but the story we are seeing is shaping up a bit differently. This is the same Fed that not long ago telegraphed that inflation wouldn't be a problem at all.
In the data immediately available on the Bureau of Labor Statistics' website, we can see that this is the first time the CPI 1-Month Percent Change has hit 0.8 in at least 10 years. And we’d have to go back to 1991 to see a time when the CPI increased this much in the first four months of a year. If the CPI continues to increase at the same rate for the 2nd and 3rd four-month periods of the year, we’ll end up with an annual CPI increase of about 6%. This is triple the Federal Reserve’s target. And the unprecedented recent inflation of the money supply (they've needed to to keep rates artificially low - more on those mechanics here) foretells a high probability the CPI will advance at even higher rates throughout the remainder of 2021.
While the CPI might not continue to increase at the same trajectory as it did in the first four months of the year, it is highly likely that we will experience at least an additional 2% each of the next four months.
In August of 2020 we wrote about the Professor Altman's research which correlates business failures to increases in the money supply. The money supply has continued to increase since then. This combination is one every business owner should pay close attention to.
The Economics Lesson
While inflation is commonly understood as an increase in prices, a proper definition is an increase in (or inflation of) the money supply. By this definition inflation has been with us for quite some time. The funny thing about inflation, however, is that doesn’t always immediately manifest itself as an increase in the price of household items. It can end up in bank reserves, or stock prices (on February 14th, before any COVID lockdowns went into effect the S&P 500 closed at 3,380. On May 7th 2021when economy hadn't yet recovered from the various lockdown restrictions it closed at a much higher 4,232), or real estate for some time before it hits main street. This likely has to do with the fact that when the Federal Reserve creates new money it doesn’t all appear in the pockets of Americans at the same time. Instead it starts with one of the Federal Reserve's primary dealers and then trickles on from there. Those who get the money first are able to use it before prices have risen and therefore have an advantage over those who receive it later when prices have risen. These distribution effects of inflation are sometimes referred to as Cantillon effects.
Guidance for owners and managers of lower middle market businesses
Prices will be rising in meaningful ways. Businesses may be able to pass these price increases on to their customers to some extent but that ability will be limited. Household wages often increase slower than general price levels. Economists refer to this phenomenon as sticky wages. Thus the average household realizing a 10% increase in the cost of the goods they might like to buy will likely need to buy those items with less than a 10% increase in the household income. They'll be squeezed and so businesses will bear some portion of thus burden.
We know that current political sentiment will likely lead to restrictions on how high prices can rise. Price controls lead to shortages. We’ve already seen difficulty for some businesses to procure key inputs and this could become more acute if price controls start showing up.
So what’s a business owner to do?
1) Capital Planning - Capital planning becomes a whole different animal in an inflationary environment. Major assets could become more expensive in the next few years. In some circumstances it might be wise to purchase now rather than later. Whereas in the past deferred maintenance might have been stretched to avoid a cash outlay, today it might make sense to catch up on that maintenance before things get more expensive.
2) Consider converting variable rate debt to fixed rates - If there is a financing you’ve been considering, now may be the time to get it done. When lenders adjust their models to bake in inflation expectations their offerings could become significantly more expensive.
3) Plan for higher safety stock in inventory - While it might be tempting to hoard a large amount of inventory now so that you’ll be able to sell it at tomorrow’s prices while realizing today’s costs, the opportunity cost will often prohibit this. Instead consider what the inability to procure a key input into your business model would do to you. If running out would be catastrophic, increasing your safety stock would make good businesses sense. We’ve talked with numerous businesses that are already struggling with procurement. If the scenario of rising natural prices and artificial price controls comes to fruition, that buffer in your safety stock could be the differentiator that allows you to deliver when your blindsided competition can’t.