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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    Appendix: Coping with Deflation: Lessons from Japan

    Many who expect a deflation scenario, including Paul Krugman and George Soros, point to the experience of Japan’s so-called Lost Decade as an example of what could happen in other developed economies today. After all, the Lost Decade began in 1990 with the bursting of asset bubbles in stocks and real estate, just as in the Great Recession. Banks, corporations, and households began to deleverage. Both private consumption and private investment were cut back. The end result: a significant demand-supply gap, two decades of sluggish growth, and long-term creeping deflation—all despite repeated rounds of government stimulus and a prolonged easing of monetary policy.

    The similarities between postbubble Japan and other advanced economies today are indeed striking. But one should be cautious about broadly applying the Japanese scenario and expecting imminent deflation—for at least four reasons.

    The Delayed Impact of Japanese Deflation. Japan’s deflation started well after the bubble burst. Japan’s real GDP growth began to drop in 1990 and has stayed low for 20 years, declining from a healthy 4.5 percent annual rate in the 1980s to an anemic 1.5 percent in the 1990s and 0.7 percent in the first decade of this century. However, the country’s inflation rate, as measured by the consumer price index, did not begin to show a continuous decline until 1999. This suggests that sluggish growth after the bursting of an asset bubble does not automatically lead to deflation. And even when price declines do occur, as in the case of Japan, the rate of deflation is relatively low, in theory giving policymakers ample time to take appropriate measures to stop it.

    The Aging of the Japanese Population. There are a number of factors specific to the Japanese situation that have contributed to the economy’s long slump and persistent deflation. One notable but rarely discussed factor is demographic: the country’s rapidly aging population. The absolute size of the Japanese labor force began to decline in 1999, the same year that witnessed the beginning of the deflationary trend. And the country’s overall population began to decline in 2007. This trend has had a major negative impact on consumer spending and corporate investments. However, similar demographic pressures are nowhere near as strong in other countries as they are in Japan—either because of growing populations or the ability to mitigate the impact of aging populations through immigration.

    The Impact of Japan’s High Savings Rates. Exacerbating the deflationary pressures in Japan is the fact that the country’s aging population has a large proportion of its financial wealth in short-term nominal assets, thus creating an intrinsic bias in favor of deflation. But precisely the opposite is the case in the United States and other Western economies. Japan’s households have net financial assets equal to 40 percent of GDP, whereas U.S. households have net financial liabilities of roughly the same proportion of GDP. This fact alone should make deflation far less socially and politically acceptable, increasing the pressure on the government to fight it.

    Japan’s Economic Policy Errors. Japan also made several policy errors that slowed its economic recovery and subsequently brought about deflation. For instance, a genuine cleanup of troubled bank balance sheets didn’t occur until 2002. And the government’s failure to change Japanese labor laws to encourage labor market flexibility slowed the transfer of workers to newer industries with stronger growth prospects. What’s more, a new policy encouraging temporary employment accelerated the hiring of nonpermanent workers in lieu of new permanent jobs: nonpermanent workers accounted for about 20 percent of the workforce in 1990 compared with 30 percent today, which is yet another factor that has eroded the spending capacity of Japanese households. In general, Western governments have moved much faster to counter the negative effects of the recent financial crisis.

    Of course, we could be wrong. As in Japan, excessive easing of monetary policy, coupled with greater government spending on public works or on assistance to less-competitive companies and industries, could slow the process of reducing the demand-supply gap and lead to deflation. The risk might be higher in the euro zone given its trade imbalances, which require a reduction of unit labor costs in countries such as Spain, Portugal, and Greece in order to regain competitiveness.

    If so, what should companies do? Deflation will be relatively easy to manage if they follow four best practices that have emerged in Japan over the past 20 years. Paradoxically, these are some of the same things that companies should be doing to prepare for inflation.

    • Build a sustainable cost advantage. When prices go down, a company must ensure that its costs go down more rapidly (relative to competitors, that is). Companies need to reassess their cost base from scratch. It’s not enough just to do across-the-board cuts; what is needed is a thorough reengineering of the cost structure throughout the entire value chain. Some Japanese companies have been able to slash costs—and, therefore, prices—by as much as 50 percent.

    • Rigorously manage pricing. Besides simply lowering costs and prices, companies also need to understand the ways in which deflation changes consumer psychology—and be far more sophisticated in setting prices. For example, a company can reduce perceived prices by simultaneously decreasing price and value through smaller package sizes, by unbundling products and services in order to offer the lowest-possible base price, by attracting customers with a low-priced initial offering and following up with additional services and features, by setting prices to mitigate customer risk or uncertainty, or by coupling price increases with an increase in the number or level of discounts.

    • Reengineer the pricing function. At most companies, there is considerable pricing volatility and leakage via discounting. In general, pricing decisions are too decentralized—and salespeople have too much autonomy to cut special deals. Instead, companies need to manage pricing more centrally in an integrated, end-to-end fashion rather than in the current siloed manner. Consider appointing a chief pricing officer.

    • Make decisive moves that change the game. In addition to better management of both costs and prices, companies should also be considering bold strategic moves to fight deflationary headwinds. Just as the best time to invest in the stock market can be during a downturn, a deflationary environment may also be the best time to make aggressive corporate investments. Think about acquiring a struggling competitor in order to consolidate the industry and thereby protect prices and margins in the core business. Alternatively, invest in marketing innovation to maintain current price points.