Understanding the economic landscape is a fundamental requirement for businesses and finance teams worldwide. One such important economic phenomenon is inflation, driven by various factors that can significantly impact market stability.
A moderate level of inflation is considered normal in a growing economy. However, high inflation can erode purchasing power and create uncertainty, while deflation can lead to decreased economic activity. Inflation can dramatically increase the cost of doing business and significantly impact finance teams.
What is inflation?
The term 'inflation' was initially introduced in economic theory towards the late 19th century. It gained prominence in the economic vocabulary thanks to Milton Friedman, an American economist and statistician. It is an economic concept indicating a consistent rise in the costs of products and services, leading to a reduction in people's buying ability. It's generally accepted that global central banks strive to maintain inflation at reasonable levels, promoting economic stability.
In the UK, the Bank of England usually aims for an annual inflation rate of 2%. As of July 2023, the country's inflation rate was recorded at 6.8%, showing a decline from the 7.9% seen in the prior month. Despite this decrease, the rate continues to be notably above the Bank of England's goal, suggesting higher price levels across different parts of the economy.
Types of inflation
Inflation is primarily categorised into two types: demand-side inflation and supply-side inflation. Each type is driven by different economic factors and requires distinct strategies for management.
Demand-side inflation
Demand-side inflation, commonly known as demand-pull inflation, happens when the desire for goods and services exceeds their availability. This mismatch can be characterised as "excessive money pursuing limited goods."
This type of inflation typically arises during periods of economic expansion when increased employment leads to higher consumer spending. Governments often respond to demand-side inflation by implementing contractionary monetary policies, such as raising interest rates to reduce borrowing and slow down economic growth.
Supply-side inflation
Supply-side inflation happens when the costs associated with production, such as labour, raw materials, and equipment, rise. To protect their profit margins producers are driven to pass on these increased expenses to consumers, leading to an increase in prices.
Supply-side inflation often results from external shocks. For example, a sudden increase in oil prices could ripple through an economy, affecting production costs across various sectors. Policymakers usually find this type of inflation harder to control as it arises from factors outside the typical scope of monetary policy.
What causes demand-side inflation?
1. Increased consumer spending
Rising consumer spending plays a pivotal role in demand-side inflation. When consumers find themselves with more money from higher wages or tax reductions, they normally increase their expenditures. This surge in demand, particularly if supply lags, leads to an elevation in the costs of goods and services.
2. Expansionary fiscal policy
Government policies can also instigate demand-side inflation. When governments bring expansionary fiscal measures (like increasing government expenditure or reducing taxes), they infuse additional funds into the economy. This influx of money can escalate the demand for goods and services, potentially triggering inflation if not appropriately controlled.
3. Low interest rates
Low interest rates can increase borrowing which ultimately leads to increased spending. Businesses as well as individuals tend to borrow more when credit is cheap. This often leads to higher demand for goods and services and, subsequently, inflation.
What causes supply-side inflation?
1. Increased production costs
When expenses related to inputs like labour, raw materials, and equipment surge, companies frequently transmit these escalated costs to consumers through higher prices. This situation results in supply-side inflation. For instance, if a country's minimum wage experiences a significant boost, businesses might opt to elevate their prices to counterbalance the augmented labour costs.
2. Natural disasters
Natural disasters can lead to supply-side inflation which is brought by disruption in the supply chain of goods and services. For example, a severe drought can diminish agricultural output, causing food prices to rise.
3. Trade policies
Trade policies, including tariffs and quotas, can also contribute to supply-side inflation by increasing the expenses of imported items and inputs. For instance, when a nation imposes tariffs on imported raw materials, local producers confront elevated input costs and might consequently raise their prices, thereby causing inflation.
What is the impact of inflation on businesses?
Inflation can affect businesses in some of the following ways:
Eroding purchasing power
One of the most direct effects of inflation on businesses is the erosion of purchasing power. As the general price level rises, each unit of currency buys fewer goods and services. This can lead to decreased consumer spending, which can negatively impact the revenue of businesses.
Increased business costs
Inflation can also increase the costs of inputs like labour and raw materials. If businesses cannot pass these increased costs onto consumers by raising their prices, they may face squeezed profit margins.
Using Advanced Financials to hedge against inflation
As inflation continues to impact companies in the UK, finance leaders are grappling with strategies to hedge against this economic threat. Cloud-based accounting systems help finance teams to counteract the effects of challenging economic conditions by allowing them to scrutinise financial performance more meticulously.
Cloud based accounting software, Advanced Financials offers a full scope of financial management functionality for finance departments, ensuring they can accurately plan, forecast, and report in a detailed manner. Its analytics capabilities provide finance teams with a way to monitor and anticipate economic trends, so they can be proactive rather than reactive. The system's flexibility means it can adapt with changing market conditions and regulatory updates.
By leveraging the transformative power of Advanced Financials, organisations can not only survive but also thrive in an inflationary environment.