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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    Why Inflation Is Bad for the Economy

    Whatever its initial benefits, the positive impact of inflation on economic growth only persists as long as inflation expectations continue to rise. If the inflation rate remains stable, it has the same effect on demand as no inflation. In his book, Parsson calls this the law of the exponential inflation: “Every inflation must compound itself at a geometrically increasing rate in order to continue to have the same beneficial effects as in the beginning" (see Dying of Money, p. 67). What’s worse, as soon as governments start to combat inflation, demand stimulus quickly turns into a demand slump. Thus, every inflationary period carries within it the seeds of a subsequent recession. And the resulting disinflation reverses all the benefits that were enjoyed before.

    In addition, inflation has a corrosive effect on business performance. It’s not just the added time and effort required to make frequent price changes—what economists, in an analogy to restaurants, call menu costs. Over time, persistent high inflation retards productivity growth. Managerial decisions fall prey to the so-called money illusion, or the tendency to mistake price increases for real gains. Because managers believe they are doing better than they actually are, they pay less attention to real efficiency improvement. For example, General Motors reported that its sales and profits in 1978 were up 77 percent and 46 percent, respectively, from five years earlier. Adjusted for inflation, however, the sales increase dwindled to 20 percent, and the profit increase disappeared altogether.

    Another way in which inflation hampers productivity growth is by encouraging underinvestment and distorting the allocation of resources. Depreciation allowances, which are intended to help companies pay for the renewal of plant and equipment, are based on historical costs and quickly become inadequate to finance inflated replacement costs. This phenomenon will exacerbate the recent trend of negative net investment in many developed economies and will further boost inflationary pressures. Even worse, resources are not directed to the most efficient investments because prices and valuations are distorted. Investors end up chasing short-term windfall profits rather than long-term real value creation. During the German inflation of 1920 to 1923, for example, the employment rate for office and administrative workers rose rapidly at the expense of production workers—and financial speculation became one of the most dominant economic activities (see Dying of Money, p. 19).

    All of these negative effects are reflected in a company’s performance in the capital markets. Despite the seemingly positive economic effects at the start of a period of inflation, total shareholder returns (TSRs), which include both share price appreciation and dividends, are typically disappointing. We studied the TSR performance of the S&P 500 during the U.S. Great Inflation of 1965 to 1985 and found that it was dismal during the three periods characterized by rising inflation rates, especially when measured in real terms. (See Exhibit 1.) TSR was considerably stronger during the periods of disinflation.

    exhibit

    There is also a strong correlation between TSR in times of rising inflation rates and TSR over the full cycle. (See Exhibit 2.) In other words, companies that destroyed more value relative to their peers during inflationary periods were much less likely to catch up and compensate their shareholders when inflation rates fell again. (See also “The U.S. Great Inflation, 1965–1985.”)

    exhibit
    Robert J. Samuelson, The Great Inflation and Its Aftermath (Random House, 2008), p. 29. For an analysis of the effects of inflation accounting on reported returns, see Russell Mathews, “Inflation and Company Finance,” Accounting Review, Vol. 35, No. 1 (January 1960), pp. 8–18.