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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.
In our first post we examined how and why interest rates are set by our central bank, the Federal Reserve, as well as the importance to small business owners of the level and direction of rates. At the time, we touched upon the “dual mandate” that the Fed has to provide both price stability and maximum employment.
When we speak about price stability in terms of the overall economy, we are touching upon the concept of inflation, which can be defined as a general rise in the price of goods and services over a period of time.
More specifically, in the U.S. we are speaking of a rise in the Consumer Price Index (CPI). The CPI is calculated by the United States Bureau of Labor Statistics and is defined as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”
At first blush we might think that inflation is, by definition, a bad thing – after all, nobody likes having to pay more for stuff. A closer inspection, however, reveals that inflation is a more nuanced concept that cannot simply be labeled as good or bad.
Mainstream economists tend to agree that a low, steady inflation rate, generally in the range of 2-3% a year, is best for economic growth. To illustrate why this makes sense, let’s look at two possible alternatives to the “low and steady” scenario preferred by economists and central bankers.
Hyperinflation is an extreme form of inflation that has been experienced several times throughout history, notably in Germany in the 1920s and in Zimbabwe in the 2000s. In both of these cases, inflation levels reached nearly 6,000% a month and led to oddities such as a postage stamp costing five billion Deutsche Marks and citizens exchanging wheelbarrows full of cash for a loaf of bread. It’s not difficult to imagine how this scenario wreaks havoc with the daily lives of everyone affected and why central bankers seek to avoid it all costs.
At the opposite end of the spectrum is deflation, the situation where the price of goods and services tends to fall over time. While this may sound like a positive – who doesn’t like a good sale? – in reality, deflation can have devastating effects on an economy. If the price of everything is always getting cheaper, then nobody has an incentive to buy anything today. And if people aren’t buying things, then companies can’t sell as many products and don’t need as many workers. This of course can lead to higher unemployment, which further reduces the demand for goods and services and can wind up with an economy that is trapped in a deflationary spiral.
Given the nasty alternatives, it is easy to see why central bankers like the “Goldilocks” situation when it comes to inflation, not too hot to risk running into hyperinflation, and not too cool to risk tipping into deflation.
In our next post, we’ll take a look at how the Fed attempts to manage inflation and how inflation can affect small business owners.
Have you ever wondered what is on Bill Gates's bookshelf?
Here's a list of his favorite books:
The Blind Watchmaker by Richard Dawkins
The Catcher in the Rye by J.D. Salinger
My Years with General Motors by Alfred P. Sloan
The Great Gatsby by F. Scott Fitzgerald
The Language Instinct by Steven Pinker
If you are thinking about making a tax-deductible donation to a small charity, you may want to make sure it is still a charity. A few recently lost their tax-exempt status for failing to file documents with the IRS. Charities, membership groups, and trade associations without tax-exempt status are not allowed to receive tax-deductible contributions and may now have to pay taxes on any income they receive.
On June 8, 2011, the IRS posted a list of approximately 275,000 groups that did not file informational reports for three consecutive years. Tax-exempt groups other than churches and certain church-related organizations making less than $50,000 a year were required to file the form for the first time in 2007 (after Congress passed the Pension Protection Act of 2006, giving the IRS a way of tracking these organizations.)
The IRS has posted the list on www.irs.gov/autorevocationlist. Information included gives the name, employer identification number (EIN), type of organization, and last known address. The list is searchable by state. They will also post monthly updates with additional information about organizations whose filing dates have come due. Donations made prior to an organization being added to this IRS list remain tax-deductible.
Publication on this list of organizations whose tax-exempt status has been revoked is intended to serve as notice to donors and others that they should not rely on a prior listing or publication. The IRS believes that the vast majority of tax-exempt groups have filed their forms and are unaffected by the revocation listing, and many on the list are simply no longer in existence.
The tax agency said procedures have been set up to help those groups who seek to have their tax-exempt status reinstated. They must fill out an application and pay a user fee, regardless of whether they originally needed to file such an application. Information on the reinstatement process can be found on IRS.gov
Have you seen the new movie adaptation of Atlas Shrugged? If not, check out the Atlas Shrugged Trailer. Its theme is the role of individual achievement in society and its goal is to demonstrate what can happen when individual achievement is undervalued, suppressed and demonized. What would happen, if our producers disappear like Steve Jobs and other industrialists fall off the radar, their companies shuttered and their creative genius no longer powering America? The answer lies in Atlas Shrugged Part I.