101: Inflation, Part 2


In the first of our two-part post on inflation we came to the conclusion that a low and steady rate of inflation, roughly in the neighborhood of 2-3% annually, is preferable to the alternatives of deflation or hyperinflation.

Central banks the world over tend to agree with our conclusion and thus seek to ensure that inflation does not get too high nor too low.  Unfortunately for central bankers, they cannot simply declare that they would like inflation to be 2% a year and have it be so.  Instead, they must use the tools at their disposal to try and accomplish this goal.

The primary tool that the Fed, or any central bank, has in its inflation-influencing arsenal is the ability to set short-term interest rates.  If inflation is too high, then the Fed will raise rates to try and slow down the cycle of borrowing and spending that leads to higher prices; if inflation is below the Fed’s comfort zone, then it will lower interest rates in an effort to prevent the destabilizing effects of deflation.  (For a more detailed explanation of how the Fed sets and influences rates see our interest-rate post).

Periods of low and steady inflation don’t just make central bankers happy, they tend to make things easier on small business owners too.  After all, if the prices of the goods and services that you need to buy for your business tend to rise slowly and predictably over time, it is a lot easier to plan your long-term budget.  In addition, if your input costs are predictable, you will find it easier to maintain profitability without having to impose large, sudden price increases on your customers.

Despite the best efforts of the Fed, small business owners are sometimes faced with periods of rather high inflation, as those of you who have been in business since the 1970s, or have read your economics history, can attest to.  Fortunately though, the U.S. has been able to avoid deflation with the exception of the Great Depression of the 1930s.

If you find that inflation, as reflected in the price of the goods and services you need to run your business, is having an adverse affecting on your operations, there are a number of things you can do in response.  First is to try and determine what is behind the rise in prices.  Is the price of one key item that you need spiking upward due to a temporary situation? (e.g. a rise in the price of coffee beans from your preferred provider due to anomalous weather).  If so, then your best bet may be to look for a substitute good until prices revert back to normal, or to look at other areas where you may be able to cut some short-term costs.

If, on the other hand, it appears that the price rise of a necessary good or service is likely to be permanent (e.g. a new tax is imposed on a critical component), and there is no acceptable substitute, then it may be time to think about raising your prices.  While this is always a sensitive subject with regard to your customers, a clear explanation of the forces behind the price hike can go a long way toward maintaining a healthy relationship.  Take the time to explain which of your specific costs have increased and highlight the fact that you are merely passing on a portion of this cost to your customers.   You will probably find that most of them are sympathetic to your plight and may even be familiar with the effects that inflation has had on their own lives and businesses.


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