Why Companies Should Prepare for Inflation

Why Companies Should Prepare for Inflation

          
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Why Companies Should Prepare for Inflation

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    An Alarmist View?

    At first glance, this view may appear to be unduly alarmist. After all, today’s debt markets suggest little expectation of inflation on the part of lenders. One way to measure inflation expectations is by comparing nominal bond yields with inflation-indexed bond yields. In October 2010, the difference between the two—the so-called breakeven inflation rate—ranged from 1.6 percent in Germany to 2.7 percent in the United Kingdom. In the United States, the estimated future inflation rate derived from 30-year U.S. Treasury bonds currently stands at 2.3 percent. Still, uncertainty is high: inflation forecasts for 2011 in the United States, again based on Treasury yields, range between 0.5 percent and 3.2 percent. (All data are from Bloomberg as of October 11, 2010.)

    Nor do the typical scenarios for inflation found in neoclassical economics, which are all based on imbalances in supply and demand, seem to fit the current economic environment. For example, demand-pull inflation occurs when an increase in aggregate demand encounters inelastic aggregate supply, such as when an economy is running at full capacity. Because companies cannot meet an increase in demand by expanding supply, prices rise—and rising prices and low unemployment allow workers to demand higher wages, further adding to the inflationary spiral. But this is hardly the case today, especially in the United States: home prices and consumer confidence are still low, and retail sales are improving but are still dampened by the deleveraging of the nonfinancial private sector. And while the strong growth of the main U.S. export partners could stimulate the demand side, supply is still very elastic, with a high unemployment rate, low capacity utilization, and at best only a moderate business outlook.

    So, too, with traditional cost-push inflation. Cost-push inflation is mainly due to a supply shock in the form of increased production costs, which leads companies to raise prices in order to protect their profit margins. The most important early-warning signal for cost-push inflation is rising unit labor costs, which indicate that wage increases exceed any improvements in productivity, inducing companies to pass the cost increase on to their customers. Although it is true that rising prices for both oil and nonfuel imports may increase production costs in the future, unit labor costs in the United States have been decreasing and pose no immediate inflationary threat.

    Once inflation takes off, an increase in inflationary expectations can exacerbate what economists call built-in inflation. If workers expect prices to be higher in the future, they are likely to ask for higher wages now in order to protect their real wages. The resulting increase in production costs is likely to be passed on to the consumer, leading to another round of price increases. But again, current U.S. economic indicators show falling price indices and low inflation expectations, so the risk of built-in inflation also appears to be low.