Inflation's Toxicity

The markets’ current obsession with inflation as the world economy is getting a mammoth fiscal shot in the arm is not unexpected. While it was argued in American Gods that the inflationary risk is low, a scenario under which reflation turns into uncontrolled inflation is worth exploring.

It is not necessary to go back far in time to the Weimar Republic’s horror stories or in space to today’s Zimbabwe to observe periods of destructive inflation. The United States suffered from The Great Inflation between 1965 and 1982, as did many other OECD economies.

Yet, today’s literature about inflation and its impact on management decisions is thin. Since being tamed forty years ago, inflation has not been a source of concern for the current generation of leaders. The best article I found through my research is from… 1975.

Inflation is a poison that distorts the markets’ functioning. Tellingly, Arthur Okun, an American economist, adds the rate of inflation to that of unemployment to calculate his Misery Indexfor any economy. Prices lose their memory and cannot be relied upon for decision-making processes. In my mind, doing business becomes akin to building a house without a yardstick.

To be precise, it is not the high inflation rate that is devastating per se. The fundamental issue with inflation arises when it loses its anchor (say, 2%) and becomes a source of uncertainty, which, in turn, renders both nominal and real interest rates highly unpredictable.

The higher and the more uncertain the inflation rate is, the more relevant the immediate term. Mid to long-term investment decisions are simply made impossible. Cash becomes a ‘hot potato’ that must be invested into durable goods, including input materials in inventory, as soon as it is at hand. But this behavior, which is contagious to suppliers and customers, further contributes to inflationary trends while accentuating the business cycles. Profit is squeezed through rising input costs (including wages) which calls for constant pricing action. The specific implications for demand must be evaluated based upon the problematic assessment of its price elasticity. Bespoke products and services become far too hard to price, pushing an entire economy to switch to more standardized, liquid solutions.

From a financial analysis perspective, performance becomes difficult to assess (most tangibly when a firm uses FIFO), which means that assets are hard to value. Besides, government rules and regulations tend to grow exponentially during high inflation periods as part of a frantic attempt to prevent the economy from spiralling out of control. The incentive for any actor to circumvent the regulatory framework increases dramatically, which puts pressure on legal and compliance teams.

An intense focus on productivity and cost savings helps compensate for the rise in input costs while smart marketing tools to support higher output prices are implemented. Working capital can be aggressively managed to collect money from debtors while lengthening payments to creditors. Strategically, vertical integration can be considered to secure the supply of strategic components. From an organizational point of view, the speed of decision-making becomes a weapon, which calls for decentralization.

But these are only mitigating factors. Uncontrolled inflation is financially, economically, and politically toxic. A de-anchoring of inflation expectations would not benefit anybody.* That is precisely why it will be avoided in the future.

* Inflation does not need to be elevated to support financial repression and to shift wealth from lenders to borrowers (including the government). What is most relevant is the achievement of negative real interest rates through ultra-low nominal rates as it is currently the case (see ‘The Roaring (20)20s’)

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