The return of Inflation: how should business respond?

 

Inflation is back and here to stay

The Ernst & Young ITEM Club Special Report on Inflation is clear: Inflation is back and here to stay. The increase in inflation rates has both external and domestic origins but it is not being created by the upward pressure on wages that we saw in the 1980s. The forecast suggests that CPI inflation is likely to go above 3% in the summer. And though inflation should cool in the Autumn, as domestic energy and food prices rise by less than they did last Autumn, it’s unlikely that inflation will dip below 2½% before 2016. By the time that the tuition fees effect falls out of the calculation in late-2015, underlying inflationary pressures will be building again as a stronger economy improves workers’ wage bargaining powers and firms’ pricing power and so the CPI is unlikely to fall. My really old nemesis, the RPI will remain above the CPI throughout the period and start to accelerate away from CPI in 2015 and 2016 as housing costs increase. This really is inflation as I remember it.

From friend to foe: time to act to preserve profitability

Inflation erodes profitability. Business was a major beneficiary of the falling inflation in the NICE decade: input costs fell as more and more goods came from offshored production and pressure on wages fell as workers saw their spending power increase. The return of inflation will hit both sides of the profit equation; reduced spending as real incomes fall and higher costs as import and domestic supply cost levels increase. Business must act now to protect profitability for the “New Normal” inflation environment, working to manage the impact on both the demand and supply sides of the equation.

It is critical to understand how a higher level of inflation will impact demand to provide the basis for developing options on how to respond in the marketplace.

  • The starting point is to identify the effect on real disposable incomes. The impact on consumers across the economy will not be uniform, individual segments will be affected in different ways. For example, tuition fees impact students as they study but will also depress spending of graduates when they reach the £21,000 income threshold and have to start repaying their loans. Similarly, if the 38% rise in food prices that we have seen since 2007 is repeated, this is likely to hit people on lower incomes, for whom food makes up a higher share of their average spend, disproportionately hard. The Ernst & Young ITEM Club analysis of the likely evolution of inflation by category is a very useful tool for developing this segment view of future income.
  • Once the impact by segment is understood, this can be mapped to product and service demand characteristics using estimates of the elasticity of demand for the particular product or service. Energy and telecommunications services have a relatively inelastic price elasticity of demand, which means  an increase in price will not lead to a proportionate fall in demand. This in turn means that a greater share of income will be taken up by these services and hence spending in other, more elastic areas will fall. This effect will of course vary in line with customer demographics but we have already seen such effects since the financial crisis with shifts in consumer spending, to own label rather than brands, and the shift to more in-home leisure spending as opposed to out of home activity.
  • Finally, it is important to develop a view on extent to which productivity improvements and / or technology development can offset the income effect. In the Technology sector for example, there have been continued cost reductions through technology developments, as well as the creation of new products and services. As such, consumers get more for less, or far more for the same amount of money. Spend in the sector has been pretty constant at around 3% of GDP, but what consumers actually get for their money has increased exponentially – eg Fixed voice to mobile, Pay TV and broadband, as well as all the content which sits on top of this. Other sectors have similar opportunities to reposition their offers and so mange the potential impact of inflation on demand by changing customer perceptions.

 

On the supply side, businesses need to revisit their forecasts and develop a more detailed view of how their cost structure is likely to evolve in the light of the latest economic growth and inflation forecasts. A key factor will be the exposure to international inputs.  – Sectors that have benefitted in recent years from outsourcing production – such as consumer electronics, clothing and food – could now see cost and margin pressure build. In addition, as we expect to see domestic property and labour cost pressures increase after 2014, now is the time to revisit business and operating models and to design the most efficient model for the future, reflecting the likely changes in both demand and supply conditions.

 

Business may need to turn to another long lost friend, the price rise.  In a deflationary or stable environment, price increases are hard to justify and very hard to sell to customers. However, if nominal prices and wages are moving up across the economy then, at some point, pricing will have to be addressed.

 

With a detailed understanding of supply and demand and particularly how productivity and innovation may change the good or service offered, businesses will be in a much better place to position and sell their new prices to increase profitability.

 


 


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