‘Economist tips decades of high inflation’

The Wall Street Journal headline, “ Economist tips decades of high inflation”, got me thinking.

Have you managed a business in this environment before? Are you and your management team ready for this? Do you have plans in place to manage this situation and most importantly do you have the business disciplines in place to execute your plans effectively?

The WSJ article focused on the views of Charles Goodhart. The Harvard graduate started working for the Bank of England in the 1960s as “an expert in monetarism”, which attributes inflation to an excess of money in circulation. He shaped the bank’s policy in the early 1980s to help Margaret Thatcher bring down the double-digit inflation rates. He was appointed to the Monetary Policy Committee under Tony Blair and his testimony to the New Zealand parliament in 1989 was instrumental in their decision to pioneer inflation targeting. While he has clearly firm views on inflation, not all his work was a stellar success. The article outlines that while working in the UK Monetary Policy Committee:

“the link between inflation and the amount of money in circulation proved to be unreliable, and the UK later abandoned money supply targets.”

Wall Street Journal

In 1983 he was responsible for Hong Kong pegging to the US dollar that ended the currency crisis and has been in place for four decades. He also warned of a build-up of leverage in advanced economies before the 2008 global financial crisis. 

The article starts out by saying,

“When the global economy tanked in March 2020, the rate of inflation looked like it was heading to zero. That made it a surprising moment for former UK central banker Charles Goodhart to predict that inflation would hit between 5 and 10 per cent in 2021 – AND STAY HIGH.”

Wall Street Journal

Isn’t hindsight a wonderful thing – we now see the inflation rate in the US at 9% and rising quickly, the UK is at 5.5% in January 2020 – the highest reading since March 1992. Our inflation rate was reported as 3.5% in Q4 2021 and the RBA is closely watching the economy’s performance. The news items are screaming of higher inflation in grocery items, fuel prices are at record highs and in my industry, contractor rates have never been higher. Making business cases more difficult to get across the line. So it would seem Mr Goodhart was/is very close to the mark on this one.

The article dug into what is causing this and made the following points:

• There is “a seismic shift underway in the world economy, one that fiscal stimulus and the post-pandemic recovery would only hasten”.
• “The coronavirus pandemic will mark the dividing line between the deflationary forces of the last 30 to 40 years and the resurgent inflation of the next two decades”. Yes, you read that correctly, decades.
• The good news is the rate would settle long term at around 3 to 4 per cent and not continue to spiral out of control as it appears on some markets at the moment.
• His “theory about how shifting demographics and squeezing the labour force and pushing up prices has drawn the attention of central bankers”. We have seen this locally when we closed the borders and could not get fruit pickers or, in my industry, IT contractors. It is interesting to examine the concept of shifting demographics as many observers use it as justification for their predictions. People like Harry Dent used this as the rationale behind his 2009 book “The Great Depression Ahead”. Ray Dalio uses this concept as one of his inputs to his analysis in his latest book, “Principles for Dealing with the Changing World Order”. Albeit Dalio’s analysis has a much longer timeline within which he examines the cycles. He goes back millennia.
• The article outlines some criticism of this analysis and uses Japan as an example where the ageing demographics and subsequent shortage of workers has not lead to higher inflation. However, Goodhart argues this is different this time because 1) the addition of hundreds of millions of inexpensive Chinese and Eastern European workers pushed down prices; and 2) the average working age is growing and birth rates are declining. As labour becomes scarce, labour rates will increase. 

Add to this labour shortage the current supply chain disruptions and the move to reshore or near-shore manufacturing activities and we have significant pressure to keep inflation operating for some time.

What can you do about this?

• The first thing is there will not be one big thing you can do to adequately manage in this environment. Your success here will rely on the combined impact of many smaller initiatives.
• Look at where you can leverage technology. Are there opportunities to add robotics to your manufacturing plant or warehouse operations? 
• Your working capital management becomes significantly more important. Your management of all the levers that impact working capital come into play here. From inventory management and procurement strategies through to AR policies. You risk customers making you their inflationary or working capital buffer. Be diligent around on-time payment.
• Your supply chain relationships need to shift from transactional to relationship-based, as do your resilience-building activities.
• Develop a deep understanding of your cost structure and most particularly your “cost to serve”. It is in times like this you need to maximise the margin on every sale.
• Make sure your offerings are both appropriate to the current market and profitable. Loss leaders should be thrown out the window. 
• Look for where value is added to your customer. Measure the value being added internally as well – this is often poorly understood and now is the time to gain that understanding if you don’t have it, and use it when you do. Focus on productivity and efficiency to create value. While inflationary times may make customers more price-sensitive, quality products and services will always win out. Is it beneficial to you or your customer to adopt consignment stock arrangements for example? What other delivery models can you investigate and deploy?
• Undertake strategic purchase arrangements – making more of the suppliers you have, while not putting your supply chain resilience at risk.
• Look at your hedging arrangements for commodities, currency and other procurement activities. There will no doubt be improvements to be gained here.
• While stocking up on inventory or buying in bulk to get larger discounts are often suggested as tactics in inflationary times to buffer against price raises – be careful. The cost of holding inventory calculation contains significantly more components than simply the purchase price. One key reason why inventory reduction programs get results is that inventory notoriously hides problems. By reducing the inventory levels you expose underlying problems in the business. By buying more you risk simply hiding your problems – and those problems will cost you significantly more than the increase in the purchase price. Do not abandon sound inventory management practices – inventory must continue to flow. Sure, take advantage of strategic buying where possible but focus those efforts on leveraging your overall spend to negotiate a price and rise and fall clauses in contracts, not solely on the individual cost price.
• Manage price rises to your customers more diligently – small and frequent increases are easier for customers to handle than large jumps.

© David Ogilvie