How can a business respond to inflationary fears?
It is difficult to ignore the mounting fears of inflationary impacts on consumers and businesses. The alphabet soup of indicators includes at least the CPI, PPI, and PCE.
The Federal Reserve (“Fed”) announced at its January 2012 Federal Open Market Committee meeting that the PCE would be the primary measure of inflation the Fed will use to assess the level of inflation in the economy. While the CPI is regularly quoted, the PCE does not achieve the same level of notoriety.
The CPI represents a basket of goods and services that urban consumers would buy without making substitutions when prices change. The PCE includes a broader range of goods and services than the CPI, and the PCE uses a broader range of buyers. The PCE attempts to track what is actually purchased and incorporates buying pattern changes when prices change.
The Fed believes using the PCE leads to a smoother and typically lower level of reported inflation.
The PCE is published monthly in the Personal Income and Outlays report. The graph below shows the value of a basket of goods from 1960 to July of 2021. The July 2021 PCE (compared to prices one year ago) was reported at 4.2%, compared to 3.6% in April and 4.0% in May and June.
What are the differences?
The Bureau of Labor Statistics (“BLS”) releases the CPI and the Bureau of Economic Analysis (“BEA”) publishes the PCE.
The CPI uses data from household surveys while the PCE uses data from the gross domestic product report and the suppliers. The CPI only considers urban households, while the PCE measure goods and services purchased by all US households and nonprofits.
The CPI only considers out of pocket expenditures on goods and services purchased while the PCE includes expenditures such as medical care paid by employer provided insurance, Medicare or Medicaid that are not paid directly by the consumer.
Inflation Indicators
Both the PCE and the CPI are showing inflationary trends. The Fed chairman announced on August 27, 2021 that that recent inflation readings are “a cause for concern”, but he sees this as a temporary trend and believes that tightening monetary policy could be a “particularly harmful” mistake.
How can a business respond to inflationary fears?
It is difficult to ignore the possibility of inflation. And, it is difficult to ignore the commodity price changes being experienced. How a business responds to the level of uncertainty and how the business plans for price changes is key to successful operations.
Here are several steps to take:
Review and summarize all contracts with customers.
Maturity dates.
Automatic renewals.
Price escalation terminology.
Review and summarize all contracts with suppliers.
Maturity dates.
Automatic renewals.
Price escalation terminology.
Review bid processes.
Are key inputs repriced in the bidding software being used?
What is the contractual price lock period during the bid process?
What is the escalation terminology in the bid and contracts?
Additionally, it is time for best practices to be employed in these areas.
Operating Cycle Management.
Accounts receivable.
Inventory.
Accounts payable.
Profitability Analysis.
By customer.
By product.
By division.
Line of Credit Management.
Structure review.
Relationships between asset categories.
Total line size.
Frequency of BBC reporting.
Would more frequent reporting help availability?
Price Volume Variance Analysis
By product.
For key inputs.
Next Steps
All companies need to evaluate their reliance on commodities and the impact of inflation on performance. It is key to understand the impact of a $1.00 per unit change in input costs – a sensitivity analysis.
Management should use the outline above to challenge senior management and decision makers to employ these best practices.
Lenders should have discussions with borrowers using this same outline.