How Companies Can Prepare for a Long Run of High Inflation
Consumers, businesses, governments, and investors are particularly concerned about recent inflation news. Thanks to demand continuing to outpace supply and Russia’s attack on Ukraine and the West’s subsequent sanctioning of Russian goods and trade, inflationary pressures and supply chain issues are real and here to stay. It’s important to develop an in-depth understanding of these problems and create a gameplan to address these rapidly evolving challenges. The authors present seven new strategies for companies to combat longer-lasting inflation.
While consumers generally dislike inflation because it erodes the purchasing power of their income, businesses desire a steady level of inflation because investments made in today’s prices yield higher profits and returns in the future. Governments also like low and steady inflation. With inflation, government’s long-term borrowing needs to be repaid at a lower real cost, and a nation’s real income keeps increasing as long as employment remains high and the improvement in worker productivity exceeds their wage enhancements. Prices of assets such as houses and equities keep rising, attracting investors into the economy. The idea is that the economy keeps growing and everyone benefits.
So, why are consumers, businesses, governments, and investors particularly concerned about recent inflation news? What’s different this time?
Why inflation is so high right now
First, despite demand for goods and services reaching or even exceeding pre-pandemic levels, supply hasn’t 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 multiple times their pre-pandemic levels. China’s zero-covid policy comes with lockdowns and closures of the world’s most important manufacturing and shipping hubs. Many factories remain closed or have not resumed operations. Wages keep rising, and companies are still struggling to hire enough talent. A widespread shortage of truck drivers is affecting production chains.
Second, compounding those factors is Russia’s attack on Ukraine and the West’s subsequent sanctioning of Russian goods and trade. These developments have direct and indirect effects that fuel inflation. Russia is still an important supplier of oil, gas, and coal to European factories. Ukraine and Russia combined are the world’s largest exporters of grains, feed crops for cattle, and fertilizers for growing crops. Cutting off these supplies or even reducing them significantly throws a wrench in a well-functioning global supply chain system. Even if the war were to end tomorrow, sanctions and trade embargoes are unlikely to reverse soon and could take years (if not decades) to sort out.
The risks of protectionism
One likely outcome of these developments is that countries could turn protectionist, reversing decades of trade and specialization progress. For example, over the last 40 years or so, manufacturing moved away from the U.S. significantly. Meanwhile, California’s Silicon Valley became the global leader in new digital businesses ideas, Taiwan became the global supplier of semiconductors, and China’s Shenzhen region created an ecosystem for manufacturing electronic products. In addition, Brazil became the largest exporter of beef, China of steel, Canada of aluminium, Germany of cars, and the U.S. of radios and TVs and refined petroleum.
In other words, each region started specializing in producing goods in which it had comparative advantage or economies of scale. Goods crisscrossed the globe at various production stages before reaching customers. This specialization and trade lowered 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 to be lower than the inflation-adjusted price you paid for a small black-and-white TV in the 1990s. This was the outcome of well-functioning specialization and global trade. In other words, countries are better off specializing in a few things and trading the rest, instead of trying to be self-sufficient.
Now there is a real danger that at least some of that progress could be lost or reversed, forever. Countries may revert to more protectionist policies and attempt to become more self-reliant. Imagine a scenario where each country attempts to have its own steel mills, produces its own cars, runs its own airlines, and has its own oilfields and refineries. In addition, many countries would spend more on defense, which means fewer funds for real development. All of this would make goods and services more expensive.
What companies should do about inflation
We don’t think inflation will be coming down anytime soon, even while the Federal Reserve plans to reduce its balance sheet by more than $1 trillion this year (that is, mop up $1 trillion back from the economy, hoping that demand will reduce to become more in line with supply).
Previous HBR articles have offered valuable suggestions on how companies should combat or plan for inflation. Given the new developments in Russia and Ukraine, the supply chain and inflationary issues have become far deeper and more prolonged than before. Here are seven new strategies for companies to combat longer-lasting inflation:
- First and foremost, understand your entire value chain and its exposure to supply chain shocks. In other words, go beyond learning about just your immediate supplier — figure out the supplier behind your supplier, and so on. Even a minor subcomponent crisscrosses the world at various manufacturing stages. Assess the risk of disruption at each stage, develop alternative sources of supply, and keep sufficient inventory. Those days of keeping lean, just-in-time inventories are gone.
- Understand your capital structure: your mix of equity shares, preferred shares, bank loans, short-term credit, supplier credit, and convertible debt. See which ones need to be repaid and when, which are affected by interest rate increases, and which could bring your business down if you default. Financial plans that worked during the last decade may be too risky for the coming years. Restructure your loans, obtain new lines of credit, and maintain enough cushion.
- Pay extra attention to global developments, realignment of countries’ alliances, and changing policies of international suppliers. These factors can no longer be taken for granted. You can’t expect that countries will act rationally in their long-term economic interests. Politics, international pressures, and national fervor could dominate rational economic thinking, leading to rapid changes in business policies.
- Pay attention to the Fed’s policy announcements and meeting minutes. They often contain well-laid-out plans and policies that can surprise businesses when implemented. For example, each recent announcement of interest rate hike has caught stock markets by surprise.
- An important challenge in the midst of the exodus of people from the job market is to keep morale high and prevent attrition. Losing a key employee means months of lost productivity and expenditure of additional efforts to find and train a replacement. Consequently, it’s especially important to be in constant communication with employees and at least be aware of their plans for switching jobs. Be more flexible in accommodating their personal needs, such as letting them work from home, which may boost employee productivity.
- The luxury of pursuing nonremunerative ideas is now gone. It’s time to rationalize activities, customers, businesses, brands, segments, suppliers, manufacturing sites, and product lines, because short-term survival takes precedence over long-term growth. Go back to the drawing board to identify core areas and focus on those that provide the best returns for finite resources while holding the most promise for future.
- A natural tendency during these times is to apply a universal axe and order an across-the-board cut of salaries, expenditures, and headcount. An obvious outcome of such actions is low morale and further attrition of talented employees. It may also be tempting to start cutting forward-looking expenditures like R&D, employee training, and advertising. We strongly advise against such blunt actions. Instead, use a finer scalpel. Design a new scorecard to rank-order activities and business lines in terms of retention priorities. The scorecard must consider the current organizational priorities while leaving room for growth and future profitability. For example, it must include:
- Return on investment based on the current market values of assets, instead of historical values
- The cash operating cycle — that is, the time it takes between investing cash in inventory to recovering cash from the customer
- Risks and uncertainties, from supply to logistics to customers’ ability to pay
- Growth, a combination of total addressable market and achievable market share
There’s no sugar-coating the fact that inflationary pressures and supply chain issues are real and here to stay. It’s important to develop an in-depth understanding of these problems and create a game plan to address these rapidly evolving challenges.