What is price inflation? Inflation represents a decline in money’s value over time. When inflation rises, the value of your dollar goes down. With less valuable dollars, prices and wages increase. Ideally, they increase gradually and in step with each other. For instance, a soft drink that costs $2.50 now may cost $3 in the future. And a job that pays $16.50 per hour today may pay $20 later on.
Inflation has been a fact of life for quite some time. A reasonable rate of price inflation is expected, but when it rises too quickly, it can create challenges — especially for small businesses and consumers who see a sudden drop in their purchasing power. Sometimes, as costs start to rise, there’s a rush to buy goods and materials prior to bigger price hikes. This in turn drives up demand, and higher demand can further increase costs. When inflation rises too quickly, wages can’t keep up. As a result, consumers often prioritize necessary purchases, reducing their spend in other areas. Depending on the type of product or service small businesses offer, this can reduce their customer base.
Whether price inflation occurs at an expected rate or suddenly, what causes money to lose value? The root cause of inflation comes from a larger supply of money, whether through increased credit in the banking system, governments printing more money or legal devaluing of currency. These cause three types of inflation, each with its own contributing factors:
- Built-in inflation is based on the expectation that inflation is inevitable. People expect prices and wages to rise over time, so they do, which creates a price-wage cycle. The cost of living goes up due to inflation, so wages follow suit. As the economy reacts to higher wages, products and surveys once again rise in price, and so on.
- Demand-pull inflation occurs when demand is too strong for available supply. When production capacity can’t keep up, prices rise in response. Typically this happens when an increase in the supply of money and credit boosts consumer spending.
- Cost-push inflation happens when production costs drive up the prices of finished products. This can occur when prices rise for energy or a specific commodity often used in production processes, like lumber or metal. Eventually, the higher production costs make their way to the end-users who pay a higher price to purchase.
Steeply rising house prices throughout the early 2020s can be attributed to both demand-pull inflation and cost-push inflation. Demand for homes shot up as many people facing stay-at-home orders decided to leave urban areas and purchase homes with more space elsewhere. Consumer demand outweighed the current supply of homes, leading to demand-pull inflation. At the same time, the cost to build new homes rose due to pandemic-related shortages and supply chain backlogs that drove up the cost of building materials and led to cost-push inflation.
Price Inflation in 2022
Two years into the global COVID pandemic, rising inflation rates reached a 40-year high. What’s behind the trend? Let’s rewind two years. During the early months of the pandemic, nearly everyone stayed put. For many, stay-at-home orders lasted even longer. Nearly anyone with the capability to work from home did. Millions of children didn’t go back to school. Instead, they learned virtually from home.
The first prices to rise were in real estate — mainly due to unbalanced supply and demand and not yet full-fledged inflation. To help an uncertain sputtering economy, the Federal Reserve kept interest rates at historic lows. These low rates, paired with people’s ability to work from anywhere and their desire to seek more space and, in some cases, less restrictions, spurred an unprecedented number of home buyers to enter the real estate market.
Stimulus payments flooded into consumers’ bank accounts while a competitive labor market caused wages to rise. Very quickly, consumers had more confidence and more to spend. While demand rose on many fronts, production and manufacturing continued to struggle, frustrated by an interconnected web of labor shortages, materials shortages, supply chain and logistics disruptions, and rising global demand for raw materials.
After vaccinations entered the scene in 2021, travel restrictions eased. More people began to travel and return to work (even if on hybrid schedules), and demand for energy spiked. And amid the rise in energy prices, Russia (the world’s largest oil exporter to global markets) invaded Ukraine. The Western world, including the United States, reacted with severe sanctions. An already crunched energy supply shrunk as governments scrambled to find other oil sources. As anyone at a gas station can tell you, energy prices have skyrocketed.
In a bid to fight further price inflation, the Federal Reserve has begun to increase benchmark interest rates while the central bank has announced a program to reduce its bond holdings. This means borrowing money, including business loans, will be more expensive during a time when costs are rising, and profit margins are narrowing. We’ll discuss how small business owners can protect their business from price inflation, but first let’s answer some common questions about inflation to ensure a baseline understanding.
How Is Inflation Measured?
The measurements of inflation are price indexes that track inflation rates over time. The Bureau of Labor Statistics reports monthly on the seasonally adjusted Consumer Price Index, which measures people’s individual purchasing power. The Wholesale Price Index (WPI) measures the cost of raw materials used to produce goods prior to reaching consumers. To best understand what these indexes mean and how they affect consumers and businesses, it’s helpful to know how they’re measured.
What Is the Consumer Price Index?
To track inflation rates, many refer to the Consumer Price Index (CPI). CPI measures the cost of living by tracking the price of a predetermined “basket of goods.” This basket includes items and services that most people need, including transportation, medical care, food and energy. CPI is calculated based on the average prices of these items for urban consumers. When compared over time, CPI is an indicator of inflation or deflation.
What Is the Wholesale Price Index
While CPI indicates direct-to-consumer prices, the Wholesale Price Index (WPI) measures the cost of goods and services related to production. You may also hear the term Producer Price Index (PPI), a similar measurement also used in the United States. WPI and PPI are used to track inflation rates at the production and wholesale level. As the cost of production goes up, business owners should carefully plan their purchasing decisions while adjusting their financial forecasts and potentially reassessing their own pricing structure.
What Is Asset-Price Inflation?
While inflation measured by CPI and WPI is a reflection of money’s value in relation to ordinary goods and services, asset-price inflation measures the value of assets like real estate, stocks, bonds and commodities. Generally, when asset inflation occurs, it’s seen as a good thing for the overall economy. Examples include the stock market rising and home values appreciating. These types of investments are tools people use to build wealth over time. Many view these assets as a hedge against price inflation’s effects.
What Does ‘Price Adjusted For Inflation’ Mean?
Put simply, inflation-adjusted prices include the effect of inflation, often for comparison’s sake. Knowing the price adjusted for inflation helps people understand, track and compare money’s purchasing power — and the price of assets like real estate — over different time periods.
Let’s say you want to see how the cost of housing in America has changed since the 1960s. According to the U.S. Census Bureau, the median home price in 1960 was $11,900. In 2021, the median price was $397,100. It may seem that the cost of a home has gone up by 3,153% since 1960, but these prices aren’t quite comparable in their current form. When you adjust for inflation (using this handy CPI inflation calculator from the Bureau of Labor Statistics), the average house price in 1960 would be today’s equivalent of $117,420. That price is still far less than $397,100, but not quite as drastic as if you were comparing today’s price to $11,900. When adjusted for inflation, the average cost of a home in America has risen by 238% since 1960, not 3,153%.
How Inflation Impacts Businesses
Inflation increases manufacturing and production costs. This can drive up the price of goods and services for consumers and businesses, alike, especially when paired with high demand. For businesses, higher expenses can translate to lower profits. When inflation rates seem to be spiraling upward too quickly, governments’ financial entities often make efforts to control it. As we’re seeing now, these efforts can make it more expensive to borrow money.
Inflation’s Effects on Small Business Owners
Nearly three-quarters of small business owners have reported at least a 20% increase in costs for supplies and services, according to a Business.org survey. The National Federation of Independent Businesses (NFIB) reports that 49% of small businesses have raised wages for staff, and 28% plan to raise compensation in the next three months. The trouble is, small businesses don’t have access to abundant savings accounts and capital markets which would make it easier to raise wages the way a large enterprise can. Many feel they simply can’t compete with large companies for labor. Small businesses also don’t have the same buying power, so they may struggle to place significant purchase orders that could help them better manage their own costs. This means they’re often more sensitive to inflation’s squeeze.
When it comes to raising their prices as a way to survive high inflation rates, many small business owners may hesitate for fear of driving away customers. In fact, according Business.org, 37% of small business owners say customers have complained about higher prices, and 30% think higher prices will deter their customers. But to cope with their increasing costs, 60% of small businesses have raised their prices, according to a Goldman Sachs survey, deciding that they must pass some of their higher costs to customers. Yet, losing customers due to price hikes is a bigger risk than it might be to large businesses with a wider customer base. Perhaps this is why, according to NFIB, small business owners identify inflation as their top concern, overtaking labor quality and labor costs.
How Small Businesses Can Survive Inflation
These eight tips can help you adapt your business to survive inflation, protecting your current income and the future of your small business.
- If you need help with cash flow as inflation continues, consider securing a business loan prior to planned interest rate hikes. If your business could benefit from refinancing its debt, you may consider joining the 16% of small business owners who plan to do so prior to rises in interest rates.
- Analyze your profit margins. Consider the products you carry and services you offer — as well as how continued inflation affects their related expenses. Focus your efforts on the ones that currently perform best for your bottom line. For all others, consider which are most important to your future. If you find that one isn’t helpful to your business now, and you have low expectations for it in the future, consider whether it’s time to remove it from your offering.
- Maintain an open dialogue and a flexible negotiator’s mindset when communicating with your suppliers. Doing so can help you build mutually beneficial, long-term relationships to support both companies during hard times.
- If possible, buy items in bulk. Not only can you stock up prior to further price increases, but you may enjoy volume discounts that drive down the cost per item while also building in an inventory cushion that can insulate your business somewhat from supply chain disruptions.
- Consider raising your prices, but do so strategically. Share news of impending price increases to customers ahead of time if possible. Most people understand and expect that prices will increase across the board, and they’re likely to appreciate the heads up.
- Communicate openly with your customers and, as always, thank them for supporting your small business. You may even consider how to use creative pricing strategies paired with subscription-type orders to help them keep prices down during inflation while maintaining them as long-term customers.
- Focus on improving productivity. Streamline your business processes, and use automation technology when possible. Doing so can help you save on current labor costs, stay resilient when hiring is difficult, and future-proof your business.
- Inflation also affects the cost of replacing equipment and rebuilding should you suffer damage to your business property. Whether you’re running a well-established small business or a start-up, evaluate your current small business insurance to ensure you’re adequately covered for today’s higher costs.
While no one is sure when inflation and its effects will ease, you can use these challenging times as an opportunity to build more resilient business practices. Those who do will not only survive and come out on the other side, but will have gained a wider depth of knowledge and experience to overcome future challenges.
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