Practical Considerations for Operating in an Inflationary Environment

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In recent months, inflation has overtaken labor market measures as the most headline-grabbing macroeconomic indicator in the financial press. Inflation typically moves the needle more than other economic measures because of its effects not only on businesses of all sizes but also on consumers.

The current inflationary environment has contributed to shifts in consumer behavior thus far in 2022, and it is important that family businesses build responses to changing consumer behavior into their budgeting and forecasting processes. In this week’s post, we take a look at key considerations family businesses should be thinking about in their response to the current inflationary environment.

Current Inflation and Consumer Spending Data

The U.S. Bureau of Economic analysis revealed in its March 31 news release that U.S. household spending rose 0.2% in February from the previous month, down from January’s revised rate of 2.7%. While consumer spending on services such as dining out, hotel stays, air travel, and recreation increased 0.9% in February given the significant decline in COVID-19 infections, consumer spending on goods dropped by 1% in February after increasing by 6.5% in January. The recent slowdown in consumer spending on goods is likely attributed to inflation. Consumer prices in February rose 0.8% from the previous month and 7.9% for the year ended February 2022 as measured by the Bureau of Labor Statistics consumer price index, representing a new 40-year peak. With these recent spending and inflation measures in mind, it is crucial for family businesses to be able to integrate an effective response to the current environment into the forecasting and budgeting process—both in the short-run and for the long-run.

Short-Run Considerations

Short-run considerations and consequences of inflation are more straight forward than the long-term impact (discussed below). Many of our clients have enacted price increases over the past six months aimed at combating rising input costs and protecting margins. For consumers, inflation has led to brand switching, both out of pricing concerns and availability due to ongoing supply-chain issues.

While these are the “headline symptoms,” perhaps one overlooked consideration for family businesses is the need for continuous, real-time budgeting and forecasting. In an ever-changing pricing environment, simply compiling quarterly and annual operating forecasts may not be sufficient. More advanced modeling tools, such as what-if scenarios and Monte Carlo simulations, can help management and finance teams plan for any number of inflationary situations and be aware of the potential implications for operating results under a variety of different scenarios. Constant vigilance is now more important than ever in allowing family businesses to respond to inflationary pressures in a timely and adroit manner.

All that to say, recent inflationary pressures have made the already difficult task of preparing operating budgets even more complex. Maintaining a greater degree of discipline in updating operating budgets and awareness of the various scenarios that could unfold is one practical step that family businesses can take in the short-run to head off potential inflationary pressures at the pass.

Long-Run Considerations

When thinking about long-run consequences of inflation on the capital budgeting process, family businesses should look beyond the simple fact that a new piece of machinery, equipment, etc. is more expensive today than it was last month or last year. While this is true, family businesses must also consider the effects of inflation on the cost of capital, which is the minimum return that an investment must generate to create value (for more information on the cost of capital and capital structure, see Mercer Capital’s “Capital Structure in 30 Minutes” whitepaper). A business’ cost of capital is comprised of two components: a cost of debt and a cost of equity. The most readily observable effects of inflation on a company’s cost of capital bear themselves out in the cost of debt, which is the effective interest rate that a company pays on its long-term debt obligations.

With the Federal Reserve’s stated goal of using interest rates hikes to combat inflation in mind, the effect of inflation on the cost of debt then becomes clear. Increases to the fed-funds rate enacted by the Federal Reserve flow through to most interest rates in the U.S. economy. For simplicity and reference, we’ll look at the Moody’s Seasoned Baa Corporate Bond Yield, which is a good approximation of the cost of debt for many private companies. At year-end 2021, the observed yield on this debt instrument was 3.37%. The yield had crossed 4% by mid-February and reached 4.51% on March 15 when the FOMC announced that it would raise the benchmark rate for the first time since 2018 in an effort to combat the persistent inflationary environment.

The practical implication of this policy stance is an increase to the cost of debt via Fed policy actions, raising the return threshold that capital investments must cross to generate a positive net present value. On the flip side, current fixed debt instruments appear more attractive as dollar payments needed to cover borrowing costs decline on a real inflationary basis (i.e., fixed rate debt payments avoid inflation). While there are countless other considerations and factors that affect a company’s cost of capital, family businesses should consider inflation as it relates to long-term capital needs and financing decisions.

For privately held family businesses, inflation has greater consequences than paying an extra dollar per gallon at the pump or the price of a loaf of bread increasing by a few cents. Family business managers and directors should be pursuing active long and short-term strategies aimed at mitigating the effects of inflation, as this pervasive macroeconomic phenomenon can have greater implications than immediately meets the eye.