Keep watch, keep calm: The impact of inflation on business

Economic data often doesn’t generate major headlines, but the latest release of the US consumer price index (CPI) did just that. The index rose 7.9% in the 12-month span ending February 2021—the steepest annual increase since February 1982.¹

The convergence of Russia’s invasion of Ukraine and new COVID-19 lockdowns in China are adding to business and consumer concerns that America’s inflation rate—now at a 40-year-high—will remain high well into 2022. Restrictions in China will likely complicate efforts to solve supply chain challenges, while the situation in Ukraine bolsters the prospects of price shocks around food and energy. So far, higher prices have mostly reflected specific supply chain issues, which will likely be resolved over the next six-to-twelve months. In the meantime, there’s reason to expect businesses can overcome inflation. That’s why many economists, including Deloitte’s, are forecasting inflation to moderate later in 2022.²

Generally, sustained inflation requires a continuous rise in broad business costs. Since labor comprises as much as 70% of total US business costs,³  sustained consumer price inflation typically requires sustained wage inflation. Though wages are rising in some industries, overall wages and labor costs remain moderate. That could change, but as the US government’s economic stimulus dissipates and the Federal Reserve hits the brakes, it’s more likely that cost pressures will also fade. See Deloitte’s most recent US Economic Forecast for more information about why we expect the impact of inflation to moderate.

For now, evidence of systemic inflation isn’t very strong. However, attentive business leaders should be thinking about what the business impacts of heightened inflation might look like. To help in their considerations, Deloitte developed four scenarios of possible inflationary developments over the next few years. The Inflation Outlook: Four futures for US inflation centers on four key questions:

1. How long will supply chain disruptions last?
2. How do inflation expectations affect wage negotiations?
3. How do consumer spending habits evolve?
4. What is the nature of monetary policy?

Our answers to these questions reveal four possible scenarios about the future of inflation: “Blue Skies,” “Sun Showers,” “Stormy Weather,” and “Downdraft.”

In the “Blue Skies” scenario, inflation will revert to recent norms of around 2%. This requires a limited Fed response and allows consumers to resume spending more on services and less on goods (as described in our Consumer Spending Forecast).

The “Sun Showers” scenario posits inflation will decline from current rates but remain elevated between 3-4%. The Federal Reserve could end up caught between the need to slow the economy and achieving its full employment goal. The result is rising unemployment (a bit) and rising inflation (a bit) from pre-pandemic averages.

In the “Stormy Weather” scenario, inflation will rise over the course of 2022 to 8-9%. In this case, a wage-price spiral feeds faster inflation. Workers demanding higher wages to keep their purchasing power intact will prompt businesses to pass on the additional costs to consumers. This scenario could force the Federal Reserve to tighten monetary policy. The result is a recession by 2023 as businesses and consumers pull back on spending plans. The impact of inflation on businesses could subside by 2023, but will remain high for some time.

The “Downdraft” scenario predicts inflation will fall surprisingly below historical norms, potentially below 1%. Business leaders’ response to supply chain problems will be robust. But just as these problems ease, consumer spending—particularly on goods—will fall off. This could leave factories with excess capacity and inventories, which will have to be sold at a discount. In this environment, the Federal Reserve keeps interest rates low, and even considers reinstating quantitative easing to maintain low unemployment.

Be prepared for changing conditions

Although there are few signs that long-run expectations of inflation are rising, neither economists nor meteorologists can forecast the future with 100% accuracy. Business leaders should prepare for a range of scenarios. The following actions can improve performance under any of the four scenarios.

• Shore up capital structure. Rebalance portfolios and lock in today’s cost of capital in anticipation of interest rate variability.
• Proactively address supply chain disruption. Focus on building a diversified supply chain with enough slack to ride out uncertainty.
• Build for continuity. Invest in systems that enable smooth operations in periods of high labor turnover (e.g., training capabilities, automation).
• Consider smart hedges. Make strategic decisions about where to hedge (e.g., pre-buying raw materials) and consider areas most susceptible to destabilization.
• Build a strategic market-sensing function. Develop internal capabilities to monitor how the future could unfold to trigger deployment of contingent strategies and hedges.