The greatest risks to your business are those that go largely ignored by owners. Inflation is one of those forgotten risks. It hasn’t been on most businesses’ radars because inflation has been kept under control for the past five years, averaging only 1.6 percent annually across key consumer goods. However, history and economics dictate it can't stay like that forever. Can you protect your money when inflation starts to rise?
The Fed's Play On Inflation
The Federal Reserve attempts to guide interest rates to achieve a balance between low inflation and high employment. Right now, it's focused on the employment side of the equation. To spark job growth, the Fed is actively working to ensure interest rates stay at near zero percent. The hope is that companies will see the opportunity to put cheap money to work. This has been the policy for more than five years and since the needed job growth hasn’t materialized, the consensus is that current policy will continue. Janet Yellen, the President’s nominee to replace current Federal Reserve Chairman Ben Bernanke, has indicated her plan to continue current policy. The danger is that keeping interest rates so low for so long increases the risk that buying fueled by cheap money will lead to inflationary price increases.
Inflation Clues: Local And Global
The Consumer Price Index is the main measure of inflation. It captures price changes in a typical basket of goods and services purchased by consumers in cities around the country. Most businesses, however, don’t buy their inventory from a convenience store. To see how inflation affects purchases by businesses, we need to take a look at the Producer Price Index (PPI), which measures the change in prices paid by suppliers of goods and services on their purchases. Energy, raw materials, inventory and other factors go into calculating the PPI. For the next several years, most forecasts show PPI increasing.
So far, potential crises in Europe, the Middle East and Latin America have failed to turn into economic disasters. The Euro hasn’t exploded, the PIIGS are showing signs of stabilization and even recovery and the Syrian crisis appears to be somewhat contained. Despite these positive developments, it’s still clear that the European Central Bank and the Japanese Central Bank are—like ours—focused on growth and are willing to tolerate inflationary risk.
What Does This Mean For Your Business?
If we do see an increase in inflation rates over the next several years, the impact to your company’s margins can be significant. The five-year period from 1977 through 1981 had one of the highest inflation rates in modern U.S. history:
Companies that had $100,000 in cash on New Year’s Day in 1977 would spend New Year’s Eve in 1981 lamenting how their cash lost nearly 60 percent of its value. In effect, what they could have bought for $63,000 in 1977 would cost them $100,000 in 1981. Even if we don’t return to those hyperinflationary days, a moderately bad run could see the value of your cash fall by 25 percent over the course of a few years. Even the American Institute for Economic Research sees this as a plausible scenario. Unless you're confident that you could negotiate a huge price increase with your customers without losing any business, you need to protect your cash from the eroding forces of inflation.
How To Protect Your Money
Protect your future cash. The first change you need to make will protect future cash coming in from new buyers. It’s important that you implement a policy of adjusting prices for inflation, especially in multi-year contracts. By negotiating a “price inflation clause” in your contracts, you can avoid having to ask for surprise price increases in the middle of a contract because of rising inflation. If inflation stays under control, you don’t have to put this into practice, which protects the buyer from unnecessary price increases. Failing to negotiate this type of adjustment could hurt your profitability significantly if we do see high rates of inflation.
Protect your current cash. The second change you should make is putting into place interest charges on accounts receivable balances. When your customers take 60 or 90 days to pay you, your company is giving that customer a free loan. In high-inflation conditions, this could cost you thousands of dollars per year. If your customers want you to loan them money, that’s fine, but it shouldn’t be a free loan.
Protect your past cash. Money that you've already collected from customers and is sitting in your checking account or in a business safe must also be protected from inflation. Traditional investments that protected against inflation like TIPS (inflation indexed Treasury securities) don’t yield enough to actually provide that stated protection. Buying commodities like gold expose your company to speculative investment risks, as the price of gold can fluctuate significantly. The best bet is to seek out “high-yield” business money market and savings accounts. These accounts typically offer an abnormally high interest rate either as a promotion to bring new business to the financial institution or if you agree to secure other services from them. These deals won’t completely eliminate your exposure to inflation but they can help offset any adverse effects.
Don’t ignore inflation. 2014 will be very different than 2013, and too much exposure to inflation will cause a significant impact to your past, current and future cash.
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