What is inflation anyway? Put simply ‘inflation’ is the rise in costs of goods and services over time. High inflation means the price of things is going up fast, low inflation and prices are going up slowly. Inflation is significantly driven by supply and demand, if demand is high and supply is low then prices will rise.
When supply issues flow into the most basic commodities (think energy in the form of oil and gas) those price increases can quickly spill over into almost everything. Take food for example; as the cost of farming, shipping, refrigerating, and selling food goes up it hits everybody’s hip pocket, now people need to be paid more just to afford exactly the same groceries they bought last week. Money, in terms of what it can buy for most people, is worth less than it was a week ago.
Why are interest rates going up? At its heart, raising interest rates is designed to discourage some consumer and business spending, the theory being that if you can restrict demand then supply can catch up and things can come back into balance. Of course, you can only restrict the supply of necessities so much, but when the RBA raises interest rates they hope that enough people will restrict their spending (or not have money to spend) that it makes a difference.
What does all this mean when you’re starting a business or borrowing money? Firstly, it’s important to recognise that one of the factors that drives inflation is high consumer spending. Part of what the central banks are trying to do by raising interest rates is to ‘normalise’ consumer spending and reign-in what they consider to be excess. Unemployment is low, wages are starting to see real growth because of the tight labour market, and people still have money to spend. Central banks don’t want to stop spending, they just want to limit some of the factors that drive up prices.
Secondly, we need to remember that life goes on even in times of rising inflation. Depending on their target markets, and the goods or services they supply, there are a range of strategies that businesses can apply to address the impacts of inflation. If you’re starting a franchise business the first question to be asking your franchisor is “What strategies are in place (or are being considered) to combat the impacts of inflation?”
Here’s a few things to consider (whether you’re already in business or planning to start one):
- Raise Prices… Now some of you might be thinking, ‘hey wait a second, aren’t rising prices the problem?’ – Yes and no. In times of inflation people expect prices to be increasing. One of the things driving inflation right now is spending power, people have money to spend, and supplies of certain things are limited. Small and medium businesses are often the last to raise prices, thinking they’re protecting their customers. The big players in town have no qualms about raising prices and/or looking to increase their margins.
If you prepared your business plan a few months ago, go back and review your assumptions. Are your costs right? Is your sell price right?
- Prioritise your most profitable products and services… It’s always worth looking at your product range and making sure you’re focused on delivering those things which give you the best margin. Highlight ‘specials’ based on what works for you, actively cross-sell, up-sell, or alt-sell. Check over your product range and make sure you’re positioned for the best margin. Everyone knows the story of American Airlines saving $40,000 per year by removing one olive from each salad. Find your olives!
- Remember, not everything inflates at the same rate… Whilst economists distill inflation down to a single number, obviously not everything increases in price at that rate. Seasonality still matters, an over or under-supply of products due to external factors (flood, war, etc.) still makes a huge difference to the price of certain things. Many of these things can change very quickly. It’s important to look for value and to not simply assume that everything is or always will be more expensive.
What about borrowing money? How do rising interest rates impact borrowers?
- The Official Cash Rate… It’s true that interest rates are rising, they’ve gone up already and they will continue to rise. Just this morning I heard the news radio talk about the stock market, the economy, and “these high interest rates”. The official Cash Rate in Australia as I write this is 0.85%, in New Zealand it’s 2.00%. Objectively, neither of these are ‘high’. They’re also only a fraction of the cost of funds for any borrower.
The rates most businesses pay for loans are far more influenced by the risk assessment that applies to them specifically, to their industry, and to the nature of their transaction. This isn’t to say that the cost of borrowing isn’t going up, but metrics like the Official Cash Rate should be considered in context.
- Lock in your borrowing power… As interest rates rise the amount that a customer can borrow will often reduce. This is because most lenders look at historical earnings only, and then consider how much you could repay if your earnings stayed the same. To make matters worse, if you’re not looking at fixed rate funding the lender will build in a buffer in case payments need to be increased. In times of rising interest rates that buffer gets bigger and your borrowing power goes down. In short if you’re confident in your business opportunity, it may not pay to wait to seek a finance approval.
- How inflation can help… A significant amount of business lending (particularly for terms of five years or less) is done on fixed rates. That means your payments never change for the term of the loan even if interest rates increase. This fixed rate funding becomes really important when you consider the impact of inflation…
Consider ‘normal’ inflation is say 3%, and we’re a company selling cups of coffee. Our coffee shop takes out a loan with fixed repayments of $200 per week over 5 years. We sell coffee at $4.00 a cup today, but we put our prices up in-line with inflation (3% every year). By the time we get to the last year of our loan we’re selling coffee for $4.50 per cup, but our loan repayments are still fixed at $200 per week. If inflation is higher we will put our prices up more but our fixed rate loan stays the same, a hedge against inflation.
What will bring inflation (and interest rates) under control?
We can expect inflation will return to ‘normal’ when supply and demand come back into alignment. An overall increase in economic activity can also bring inflation down, but there’s little doubt that much of the sharp inflation we’re seeing now is caused by a range of chronic supply issues in the face of sustained high demand. It’s easy to blame Covid, or Russia, or floods, or El Nino, but ultimately it’s no one thing causing high inflation, and it’s no one thing that will bring it back down again.
As a final thought, it’s important to remember that inflation is actually normal (much as some news outlets might try to make us believe otherwise, remember bad news sells best). Zero inflation is an abnormality in our economic system (Official Cash Rates of nearly zero aren’t normal either). In mid-1985 base interest rates were about 16% and going to see Top Gun at the movies would set you back around $5. Here we are some 35+ years later, movie tickets still seem a bit steep to me (and don’t get me started on the price of popcorn) but I’ll be in the middle of the theatre next week with Tom, doing Mach 2 with what’s left of my hair on fire, and happy enough to pay the price… inflation be damned.