Strategy Byte - Week 30 Inflation effects

Recap

During Week 29, we explored what drives inflation & classified them as :

1. Demand-Pull Inflation
2. Cost-Push Inflation

Demand - Pull Inflation

Demand-Pull Inflation occurs when the demand for goods exceeds their supplies & due to shortage in supply of those goods & services, their prices increase.

This type of inflation is accompanied by lower unemployment & higher disposable income which ultimately raises GDP.

Causes of Demand-Pull Inflation are :

1. A Growing Economy
2. Expansionary Monetary Policy
3. Expansionary Fiscal Policy

Cost - Push Inflation

Cost-Push inflation refers to inflation caused by increase in cost of production. When the cost to produce any goods or service increases, suppliers increase the price of final goods or services & this causes cost-push inflation.

The implications of higher production costs are :

1. Contracting Supply due to reduced demand
2. Higher Prices

In cost-push inflation, due to high prices, demand actually falls resulting in contraction in economic activity & lowers GDP. For suppliers, this results in lower output & profits.

Causes of Cost - Push Inflation are :

1. Rising Fuel Costs
2. Rising Food Prices
3. Higher Taxes
4. Higher Wages
5. Supply Chain Shocks & Natural Disasters

We ended with the below questions :

1. Why is Inflation Bad &
2. What impact does it have on our lives, company strategy & the overall economy

Impact of Inflation

Let us classify the impact of inflation under :

1. Erosion of Purchasing Power
2. Erosion of Wealth
3. Impacts Resource Allocation

Erosion of Purchasing Power

Let us assume in July 2023, our monthly grocery purchases amounted to USD 1,000 for a certain basket of goods. Now, in July 2024, the same quantity purchased now amounts to USD 1,200 or USD 1,000 buys lesser quantity than what was purchased in 2023.

It means USD 1,000 has less value in 2024 than it did in 2023 or in other words, our purchasing power just eroded by 20%

[(1,000 - 1,200)/1,000 = -200 / 1,000 = 20% erosion]

The below statement from US Bureau of Labor Statistics makes it very clear :

The purchasing power of a dollar in 2022 was about 92.6% of the purchasing power of a dollar in 2021. This means that the purchasing power of the dollar declined about 7.4% between 2021 & 2022 because of inflation or stated another way , a dollar in 2022 could only buy 92.6% of what it could buy, on average, in 2021. (Source : here)

From the above, we can now define "Nominal" & "Real" value of a currency.

Nominal & Real Value of a Currency

In economics, nominal value refers to the value measured in terms of absolute money amounts, whereas real value is considered & measured against the actual goods or services for which it can be exchanged at a given time.

Real value takes into account inflation & the value of an asset in relation to it's purchasing power (Source : here)

To make it simple from our example above - assuming 2023 as the base year, USD 1,200 spent in 2024 is called nominal dollars spent (actual amount spent) while USD 1,000 (equivalent value excluding inflation or actual value of the goods) is called real dollars. The nominal & real dollars is computed using the Consumer Price Index discussed in Week 27

The impact of the above loss in purchasing power is that people with sticky wages will consume lesser goods & services as prices increase without corresponding increase in wages.

Collectively across the economy, this causes reduction in aggregate demand. This reduction in aggregate demand impacts production across the economy as suppliers will reduce their output resulting in lower spending & reduced GDP.

Inflation can also impact GDP growth numbers. How? Let us understand Nominal GDP & Real GDP

Nominal GDP & Real GDP

We defined GDP in Week 11 as below:

GDP or Gross Domestic Product measures

1. The monetary value of final goods & services - i.e., those that are bought by the final user
2. produced in a country in a given period of time (say, a quarter or year). (Source : IMF)

It counts all of the output generated within the borders of a country. GDP is composed of goods & services produced for sale in the market & also includes some non-market production, such as defense, education services provided by Government.

Nominal GDP & Real GDP both quantify the total value of all goods produced in a country in a given period of time. The only difference between the two is that Real GDP is adjusted for inflation, Nominal GDP is not. So, Real GDP will always be lower than Nominal GDP.

Real GDP is used by countries to compared GDP across time periods to exclude the impact of inflation & to identify growth only on account of increased output.

Erosion of Wealth

A natural corollary from the above erosion in purchasing power is that it also results in erosion of wealth.

The below points from FT Wealth highlights the impact of inflation on wealth erosion (Source : here dt Oct 27, 2023) -

1. The real value of fortunes has been eroding in the past two years at it's fastest rate in more than 40 years, with inflation at it's highest since the early 1980s in the US, UK & the EU.
2. In dollar terms, inflation reduced wealth growth by 6 percentage points last year, turning a nominal wealth gain of 3 - 4 % into real wealth loss of 2.6%. It's hardly a surprise, given the upsurge in inflation which hit 8.3% in the US.
3. Whats more striking is that, even in the previous two decades when inflation was low, rising prices still managed to eat away at asset values.

Impact on Resource Allocation

Any source of funds has a cost - Nothing comes free in life. So, if a firm has equity capital, the share holders expect a certain level of return on those funds. With inflation, that expectation becomes higher. This increases the cost of capital of companies. If companies' return on their invested capital does not cover this increased cost of funds, investors will take their money elsewhere.

Hence the hurdle rate of return (minimum rate expected) on a company's investments become higher & impacts decisions on long term projects & investments.

Inflation also impacts the amount of cash a company holds as it's value dwindles in a high inflationary environment.

Inflation also raises uncertainty in pricing decisions as cost of producing goods & services increases. But raising prices blindly in line with costs can impact demand & hence companies must tread a fine line between price rise & inflation.

Strategic Options

An inflationary environment can change the value proposition of a company's products or services by reducing the gap between cost to company & customer's willingness to pay in an uncertain environment. Companies can respond to the same by

1. Increasing prices to maintain the value gap or
2. Accepting smaller margins by reducing product costs

But, are these the best & only options or are there better ways for a company to navigate the rough waters of inflation? Keep this question in mind. We will explore them later.

Next week, let us explore another Government policy which impacts the key macro-economic variables - Fiscal Policy.