Inflation Is Here - What Now?
Inflation Is Here - What Now?
Inflation vs. Inflationary Pressure
Concerns about the elevated inflationary environment continue to persist. There are numerous contributing factors such as a rapid increase in wages, energy prices and an imbalanced global supply chain with demand vs. supply for many goods and services far from equilibrium. To better understand these factors, it is important to first distinguish inflation from inflationary pressure. Inflation is typified by a sustained increase in the general price levels in an economy, while inflationary pressure is described as either a leading indicator of actual inflation or temporary pricing increases due to isolated or short-term events.
While there has been much discussion and debate around these topics, the distinction is critical because the potential impact and the strategic decisions made by companies can vary greatly depending on how leadership views or interprets the economic data. As many business leaders and economists debate the short-term and long-term inflation outlook and corresponding actions as the economy recovers, it is prudent for executives to take a proactive approach by evaluating various courses of action that could address the potential for longer-term inflation.
Current Indicators, Statistics and Projected Outlooks
Federal Reserve Chairman Jerome Powell addressed this topic in a December 15, 2021 press conference, stating in his remarks: “We understand that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. We are committed to our price stability goal. We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched. We will be watching carefully to see whether the economy is evolving in line with expectations.”
The U.S. Bureau of Labor Statistics reported the Consumer Price Index (CPI) for All Urban Consumers (CPI-U) increased 0.5% in December 2021 on a seasonally adjusted basis after rising 0.8% in November 2021. The index for All Items rose 7.0% for the 12 months ending December 31, 2021, the largest 12-month increase since the period ending June 30, 1982.
The largest contributors to the seasonally adjusted All Items increase included the indexes for Shelter, Used Cars and Trucks, and Food. While the Food index did increase, the percentage increase was less than in recent months, rising 0.5% in December 2021. The Energy index declined in December, ending a long series of increases; it fell 0.4% as the indexes for gasoline and natural gas both decreased. For further details, see Table A below.
Table A. Percent Changes in CPI for All Urban Consumers (CPI-U): U.S. City Average
(Seasonally adjusted changes from preceding month)
Source: U.S. Bureau of Labor Statistics, December 2021
As of December 15, 2021, the Fed signaled there could be as many as three rate hikes coming in 2022, with two in the following year and two more in 2024. The Federal Open Market Committee significantly increased its inflation outlook for 2021, raising it to 5.3% from 4.2% for All Items and to 4.4% from 3.7% excluding Food and Energy. For 2022, the Committee now expects 2.6% for headline inflation and 2.7% for core inflation, both up from its September meeting.
Most Impacted Industries and the Effect on Capital Markets
While we have seen energy prices rebound from historic lows, volatility in those prices remains elevated as the impact of new COVID-19 variants, travel restrictions, and corporate and governmental responses continue to evolve. What we are currently observing is a quicker return to pre-pandemic demand levels in most industries, coupled with a longer and slower return of labor to the workforce, as well as supply chain channels that are still disrupted due to previous and new challenges created by the COVID-19 crisis.
The generally V-shaped recovery we are experiencing has been accelerated by widespread COVID-19 vaccinations, relaxing of business restrictions, trillions of dollars of government-backed relief programs, and increased household savings. These factors have stoked demand by U.S. consumers which will likely help recovery in the energy, travel and hospitality sectors. The most notable industry-specific effects typically observed during inflationary periods can be summarized as follows:
Industries typically benefiting from inflation: Energy, Financials and Materials
Industries typically declining from inflation: Real Estate, Consumer Cyclicals, Travel & Hospitality (Leisure), and Technology
To understand the true impact and potential courses of action, each industry should be evaluated in greater detail and at the sub-sector level, as not all parts of an industry are affected the same way. Stay tuned for additional analysis and perspective in the coming months, as our industry groups dig deeper into the 2021 data and provide their perspective on the short- and long-term implications of sustained inflation.
Key Observations and Challenges
Global supply chain disruption and pent-up demand for goods and services have challenged some of the more recent procurement, distribution and inventory management models. For many companies across a number of industries, the concept of “just-in-time” operations is breaking down where the predictability of timing and availability of supplies and materials have significantly declined. For many companies, at a minimum, longer lead times have been the outcome.
Companies with highly manual and under-developed budgeting, forecasting and planning, and analytics capabilities are struggling to determine how to respond as market conditions continue to evolve due to inflationary impacts.
Historically low interest rates have benefitted both companies and consumers for over a decade, but the cost of capital is on the rise. This will likely have a multi-pronged impact on the economy:
Price increases generally outpace increased wages, eroding consumers’ disposable income for non-essential goods and services.
Debt service requirements will increase as interest rates rise, potentially putting pressure on both a company’s ability to cover its principal and interest payments and its ability to meet traditional financial covenants typically found in credit agreements.
Enterprise and asset valuations may decline, which could cool or dampen the historically high M&A activity witnessed over the past several years. That being said, there is still a significant surplus of “dry powder” in the capital markets, with private equity capital estimated to be in the $2 trillion-plus range globally.
Companies are struggling to attract and retain talented employees at all levels and in all parts of an enterprise. These challenges are causing a short-term reactionary move to increase wages and convert potentially transitory components of inflation into longer-term or permanent cost increases to their ability to produce goods or deliver services.
Continued political debate on the appropriate courses of governmental action and intervention is a) adding to the lack of predictability in future market conditions and b) could accelerate and/or exacerbate the current inflationary environment.
Courses of Action to Consider
Many economists, business leaders and investors agree that some of the inflationary pressures being felt are temporary and normal for a recovering economy. Nevertheless, those inflationary pressures could persist for longer than anticipated, and a proactive approach is therefore advisable.
The key courses of action to consider include:
Recognize signs that indicate a business model needs to transform, such as significant changes in consumer and/or supplier behavior, lack of availability of critical resources, new and additional needs to manage and engage with a company’s talent and workforce, leveraging technology to enable future growth, etc.
Invest in more sophisticated financial planning and analysis capabilities and be able to model multiple scenarios to understand what strategic decisions and courses of action should be made proactively vs. reactively.
Take advantage of current aggressive capital markets to restructure the balance sheet accounting for increasing interest rates, decreasing enterprise and asset valuations and overall profitability impacts (e.g., additional debt service requirements, reduced margins, declining revenue streams).
Be grounded and disciplined in economic fundamentals — such as supply and demand curves/paradigm shifts, pricing elasticity, macro and micro factors, internal vs. external control — and develop a continuous monitoring mentality.
Reach out to experienced professionals (e.g., lenders, attorneys, investment bankers, analysts, consultants) for a variety of perspectives to apply to your organization, as appropriate.
BDO can help your business evaluate the best course of action to mitigate inflation risks. Contact us to take a proactive approach.
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