Understanding Inflation

By Gregg Schoenberg Monday, August 15, 2011

Previously, we examined how 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

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.

Deflation

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. 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.

How the Fed Influences Inflation

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. 

Learn more about how the Fed sets interest rates.

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, 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.

*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

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