I have been concerned about inflation for the past two years. Low unemployment, higher energy costs, and misguided government policies have all made the hairs on the back of my neck stand up due to my fear of what havoc inflation could bring to this economy. It seems the Fed now shares my worry.
Many entrepreneurs have never had to do business in an age of inflation. In fact, the last bad inflationary period we had was almost thirty years ago. Since then, careful control of the economy with interest rate policy has helped to keep things in check. I am reminded of this every time a young entrepreneur asks me what it is like to live in inflationary times. I have to remind myself that if they are under 30, inflation is not even in their vocabulary. And even if they are 40, they were young kids the last time we had to deal with an inflationary economy.
Periods of inflation create panic and fear. A mob mentality erupts, with people trying to spend and buy before the price goes up even more. And that is what the beast of inflation lives on. Panic buying just makes inflation worse. Interest rates are pushed up and up and up to try and tame the beast. Some of us remember 18% mortgage rates. I had just finished an MBA in Finance the last time we faced this scenario. It was a scary time to be trying to enter the job market. Financial institutions were in disarray -- none were hiring and most were laying people off with much more experience than we had just coming out of school.
Recently, many small business owners have begun to feel the pinch of inflation. Health care costs, energy costs, and many raw material costs are pushing up prices on almost everything. Add to that labor shortages in key areas, and you have the recipe for inflation.
During past periods of inflation we were still in the old economy. Big companies could pass along the increased prices to consumers, who due to stronger unions in those days were able to push wages higher to keep up. If their ability to raise prices fell behind, they had lots of cash reserves and knew that they could soon catch up. They just laid people off, shrunk inventories, and tight supplies then pushed up prices. All of this would continue until the economy ran out of gas. We then had a recession to cool things off.
But, we are now in an entrepreneurial economy -- remember 50 cents of every dollar in the economy are being generated by small businesses. Small businesses are always tight on cash flow. And if their inputs of raw materials and other direct operating expenses go up, they may not be able to pass along these costs quickly enough to keep their cash flow positive. And they certainly don't have large cash reserves to ride out the recession that is likely to follow an inflationary period.
So why the current worry about inflation? Hasn't the Fed got this all under control?
Unfortunately, many of the major causes of inflationary pressures right now are not within the ability of the Fed to control. Many of the top oil producers in the world do not have the most reliable governments. Iran, Russia, Venezuela, Nigeria, and Saudi Arabia are all among the top 10 exporters of oil. Many of these countries may soon make good on their promise to use oil as a weapon and hold back supply. If that happens, our current gas prices would seem like a nostalgic memory from days gone by. There are predictions of several more years of bad hurricanes. Some say even one more bad season is more than our economy will be able to take. We dodged the bullet this year, but we are still in a period where bad storms are likely for several years to come.
Another change that makes inflation harder to control is that we are in a much more open, global economy than we have been in the past. When we had inflation in the mid-1900s, everyone was faced with the same pressures and all could raise prices in relative harmony. Today inflation is quite variable around the world. Therefore, foreign competitors might not face the same inflationary pressures that we do in the US. That would put us at a huge price disadvantage. This is particularly an issue with our skilled labor shortage.
Finally, China and India are lurking. Both countries see themselves as the potential economic superpowers of the next century. They are big enough, strong enough, and centrally controlled enough to potentially use inflation and a weak economy in the US as wedge to gain advantage in the world economy.
So what can a small business do these days to try and weather this impending inflationary storm? Get back to basics and manage conservatively:
- Keep overhead low.
- Build cash reserves to buffer short term price increases that precede your ability to get higher prices from your customers.
- Watch your margins carefully. Worry about growing profits, not sales.
- Don't lock into long-term contracts that have narrow margins with large customers.
- When inflation heats up even a little, be aggressive with frequent small price increases rather than waiting and trying to catch up at some point with one big jump.
- Pay down variable interest loans ASAP, especially now that interest rates are temporarily back down. As long as there is inflation, interest rates will keep going up over the long term.
