Effects of Inflation on Business: The Good and The Bad

When inflation is in the news, it's often coupled with confusion and speculation. Everyone understands that inflation means rising prices. However, that is where the clarity about inflation usually ends. While those "rising prices" are a national average, the way inflation affects an individual business depends on its unique economic circumstances: what industry it's in, how its particular costs are rising (or falling), the productivity of its workforce, the nature of its supply chain, the level and type of its debt (if any) and so on. As a result, generalised inflation advice for small businesses can seem confusing and contradictory.

But knowing how to really prepare and adapt your business to inflationary trends can be a boon. Smart choices can help a business not only weather inflation but come through it stronger.

What Are Inflation Effects?

Even though price inflation erodes the value of people's and businesses' money, not everything about inflation is cause for panic. In fact, economists believe a healthy growing economy requires a low but positive level of price inflation, which is why the U.S.'s central bank — the Federal Reserve — uses monetary policy to target a 2% annual inflation rate. At around 2% per year, inflation is considered in the "Goldilocks zone" for strong economic growth without much risk of rising unemployment. If the rate of inflation falls too far below that target, the nation risks a stagnating economy; if the rate of inflation rises too far above the target, inflation effects can become unpredictable as they ripple through the economy and influence buyers' behaviours in both rational and emotional ways.

The simple concept of supply and demand is the core starting point for all inflation effects on businesses, no matter how far out the effects ripple or how complex they become. At the highest level, this means that if the supply of money in an economy is too high relative to the amount of goods and services available for sale, prices will rise. The Fed follows an "inflation-targeting" monetary policy, which means its actions are meant to manage the nation's money supply relative to economic growth so that inflation stays in the Goldilocks zone and unemployment stays as low as possible without driving up inflation (known as the nonaccelerating inflation rate of unemployment, or NAIRU). The principles of supply and demand also come into play when businesses experience inflation effects, such as rising raw materials costs, higher interest rates and rising (or falling) unemployment — and when they consider how to raise their own prices.

Alongside those well-understood inflation effects, supply-and-demand principles can lead to some unexpected consequences. For example, the overall effect of high inflation is to dampen total demand in an economy because goods and services become more expensive and the value of people's incomes diminish. But in times of accelerating inflation, demand for any given product — especially essential goods — might suddenly spike because customers worry that inflation will continue to rise and decide to stock up before their purchasing power drops further.

In virtually all cases, a business's best long-term response to inflation effects will involve increasing cost efficiency, productivity or both.

Video: Strategies to Deal With Inflation

Key Takeaways

• Inflation occurs when prices rise and the purchasing power of money goes down.
• Businesses are not equally affected by inflation. Nonessential goods and services tend to feel the effects more.
• Businesses have several options to cope with inflation, such as raising prices, cutting costs, reevaluating business practices and changing supply tactics.
• Inflation isn't always a negative. Many businesses can come out of an inflationary period stronger than when they entered.

Inflation Effects on Business Explained

In its February 2022 survey of small business owners, the U.S.'s National Federation of Independent Businesses (NFIB) reported that 26% of respondents named inflation as their single biggest problem, more than any other. (The quality of labour was second, chosen by 22% of respondents.) In the year-prior survey, only 2% named inflation their biggest problem. What changed?

Inflation, of course, spiked in the intervening year. The economy had been shut down due to the COVID-19 pandemic for many months, during which people were able to save money. When the economy reopened, there was too much money chasing too few goods, as economists like to say. That misalignment is expected to work itself out over time, but the resulting inflation has already lasted longer than economists expected. Now the Fed is raising interest rates to combat inflation, and the future path of the economy has become uncertain.

What is clear: Inflation will remain high for at least the foreseeable future. With it will come many changes to the economic environment to which businesses must adapt.

Does inflation affect all businesses the same?

Not all businesses are equally affected by inflation. When customers rely on a business and, by choice or circumstance, are less willing to shop around, price hikes won't alter demand as much as they would for an optional good. Therefore, many businesses, like grocery stores, healthcare providers, childcare and tax professionals, are considered recession-proof. But with discretionary goods, a purchase that can be put off until next month — or longer — probably will be.

In general, inflation has less of an impact in the following instances.

• Essential goods and services are less affected.

  Generally, essential goods don't see a huge change in demand when prices rise. For example, many workers need gasoline to get to work and will be more likely to put off other purchases than to let their tanks go empty. When prices rise, nonessential goods have a higher elasticity of demand, as customers prioritise their essential needs first before spending their depreciating purchasing power on discretionary things like entertainment or vacations. Businesses that provide essential goods and services tend to be less affected by inflation.

• Markets with few sellers are less impacted.

  If customers have few alternatives, a rise in price may not be enough to push them to look for another place to spend their money. Think about a small town with only one grocery store. If the price of fruit goes up due to inflation, townspeople may not have many other options to get their food. They're more likely to pay the higher prices rather than driving to another town to check out the competition, especially if gas prices are rising right alongside the cost of apples and oranges. On the supply side of things, businesses that rely on only one supplier may have a similar experience and be forced to pay higher prices for their goods, unless they can diversify their supply and find competing suppliers that can beat the rising prices.

• Known brand power insulates businesses.

  Businesses with a loyal customer base also tend to be less affected by inflation, all other things being equal. Customers loyal to a particular brand are unlikely to change their preferences, especially if prices in the competitive set are being affected by inflation in a proportional way. Generally, the more loyalty a customer has to a business brand or product, the more reliably the business can count on them to stick around through the stress of rising prices. But be warned: Every customer has their breaking point when an alternative becomes viable. And when supply chains are disrupted to the point where certain products simply cannot be obtained, as they have been in the past two years, brand switching will rise.

How does inflation affect businesses negatively?

Inflation can have some real negative effects on a business, and not all of them are as obvious as "everything costs more," even though that's right at the top of the list. Many inflation effects are the result of buyers' emotional reactions to rising inflation, and they're not always predictable. Here are some of the ways inflation can hurt businesses, some of which are obvious and others less so.

• Increased cost of raw materials.

  Whatever a business needs to manufacture a product or restock its shelves will likely cost more as inflation continues. When the price of raw materials goes up, many businesses raise their prices to offset their increased costs. If that happens throughout a nation's economy, you can end up with upwardly spiraling inflation that economists call "cost-push" inflation. But even this most obvious inflation effect is not universal — the prices of any given business's raw materials will depend on the supply-and-demand characteristics of that market. For example, if your business's inputs come from a country with higher inflation than your own, your costs could go down in real terms because of the behaviour of foreign currency exchange rates during inflation (discussed below).

• Supply-chain disruptions.

  Inflation doesn't disrupt supply chains; rather, supply-chain disruptions can cause inflation. But inflation and supply-chain disruptions often occur together, so businesses should have a plan to deal with them. When supply chains are disrupted, businesses can't get enough of the inputs they need, when they need them, and that lack of supply causes prices to rise. Businesses become willing to pay more for goods that are crucial to their products. It's good practice to have multiple suppliers and to test the resilience of your supply chain; that practice can make all the difference for a business during times of high inflation.

• Overhead increases/inventory costs.

  When inflation is high, the cost of everything starts to increase. Rising rents, utilities and employee wages drive up an organisation's overhead costs. When gasoline prices rise, deliveries cost more. All of these rising costs can strain a business, especially one with limited margins. A business's inventory can be affected in multiple ways: Two negative effects are that the cost to carry inventory is likely to rise, as is the cost to build new inventory (i.e., the cost of goods sold, or COGS). On the plus side, high inflation can make the value of existing inventory rise compared with the original sunk cost to build it, which was paid with "older" money.

• Decreased consumer purchasing.

  As prices rise, people buy less, and this overall effect of dampening consumer demand ripples throughout the economy. But it's important to note that the effect is not evenly distributed. Some goods, especially essential ones, will see no falloff in demand. Some will see demand rise. But most will see a decrease as consumers reprioritise their spending. For businesses selling discretionary goods and services, demand may continue falling throughout extended inflationary periods, especially if high prices are squeezing out buyers. Keep an eye on your market and make sure your prices remain competitive to keep as many customers as possible.

• Higher interest rates.

  When inflation rises, so do interest rates. That's because interest rates are the main inflation-fighting tool of a central bank such as the U.S. Federal Reserve. The Fed raises interest rates to combat inflation, the higher interest rates make borrowing money more expensive, and, in that way, they help to stifle demand for goods and services so that inflation falls. But for businesses, higher interest rates translate into a higher cost of borrowing for working capital and for investing in the business's future. For businesses that must borrow when inflation is trending high, fixed-rate loans are considered safer than adjustable-rate loans.

• Stymied investments.

  Because borrowing money becomes more expensive during inflationary times, it can sometimes become harder for a business to invest in its future, especially if high inflation ends up leading to a recession. Savvy business investors, though, know that inflation will also drive up their future returns, thus balancing the increased cost to invest. Professional investors, for example, will expect their investments to have an appropriately higher "headline rate" of return — the rate before distorting factors such as inflation are removed — so that their real rate of return matches their investment goals. Still, emotional responses are a crucial component in business and personal investment decisions, and many investors choose to put their money in lower-risk and/or inflation-indexed assets during inflationary times.

• Foreign-exchange effects.

  Here is where the "uneven distribution" of inflation is most clearly seen. Since inflation varies from country to country, countries in which inflation is higher will see the value of their currency fall relative to the currencies of countries with lower inflation (not counting other factors). Thus, a business in a high-inflation country could find its actual costs hit with a double whammy if its suppliers are in low-inflation countries. Importantly, the effects are opposite for importers and exporters. Businesses importing inputs from lower-inflation countries will be negatively affected because their costs rise in terms of their own currency. But an exporter may see demand rise because their goods become less expensive in the other country.

• Reduced employment and growth.

  The relationship between inflation and employment is convoluted, which is why some people think high inflation reduces employment despite economists' widely held belief that inflation and employment rise and fall together. This relationship is mathematically expressed in the Phillips curve, which posits a stable inverse relationship between inflation and unemployment. In other words, as inflation rises, unemployment falls (and employment grows). Remember, inflation occurs when there is more demand than the economy can fulfill. In such times, businesses are likely to hire as many workers as possible as they try to grow to meet demand. It's only later in an inflationary cycle, when the central bank has raised interest rates and made money more expensive to fight inflation, that economic growth begins to slow or stop and employment can be reduced. This usually happens only when efforts to fight inflation bring about a recession.

• Price increases passed along.

  Many businesses are forced to raise prices to cover their increased costs. But if prices rise too high, demand could drop, especially as customers reassess their own financial priorities and identify where they can cut costs. In fact, stifling demand is a goal of policymakers who are fighting inflation. In such periods, it's important to observe your competitive set and use that intelligence to help decide when and how high to raise your business's prices. A focus on maintaining customer loyalty and flexibility could be a benefit in periods of inflation. At the same time, though, you don't want your prices to fall too far behind competitors' so that you maintain the business's margins and are able to continue investing for the future.

How does inflation affect businesses positively?

Despite all of the dire warnings, potentially good things can come from inflation for a business, too. Knowing how to turn the warning signs of a coming inflationary period into benefits can save time, money and prevent a disruption in the workforce that often accompanies volatile economic periods.

• Price increases grow revenue.

  When a business gets more dollars for the same volume of products or services, revenue rises — and year-over-year revenue and earnings comparisons look better than they otherwise would. Yes, everyone knows that because of the inflation those dollars may buy less than they did last year. But don't overthink this, since markets usually don't. Just proudly display those growth charts.

• Reduction in unemployment (in some cases).

  Remember the Phillips curve and inflation's convoluted relationship with employment. Early in an inflationary cycle, unemployment should be low, making it hard for companies to hire good people in such a tight labour market. Smart businesses may want to wait before hiring but prepare themselves for the usual transition from low to high unemployment that comes later in inflationary cycles (when recession becomes a possibility). That can be a great time to hire much-needed workers as more people begin looking for work. Plus, a more diverse hiring pool can bring with it a wider range of talent and skills.

• Margins improve on existing inventory.

  Having high inventory heading into an inflationary period gives a business the opportunity to benefit by selling that inventory at a higher price than it originally planned. That increases the business's profit margin because the inventory was already a sunk cost. As long as inflation doesn't drive up the company's cost to carry the inventory by too much, such a fatter margin could become a useful competitive weapon, providing extra dollars to offset higher costs elsewhere or empowering a market share growth strategy by undercutting competitors' pricing.

• Can make old debt cheaper.

  Existing debt becomes cheaper to hold on to in current "real" dollars as inflation erodes the value of money. New debt can get more expensive as interest rates rise to combat inflation, so hanging on to that old debt is worthwhile. For companies that don't have much debt, take note that new debt becomes old debt pretty quickly if inflation is very high for an extended period. If you expect such a long-term inflationary trend, it may be wise to add debt early in the cycle so you can use it to the business's advantage later in the cycle, when borrowing costs become too high for your competitors to handle.

• Increased employee costs.

  Higher wages may not seem like a benefit to a business trying to cut costs, but they force a company toward the one thing the economy needs to kill inflation and that a business needs to emerge stronger in inflation's aftermath: higher productivity. By increasing worker productivity, businesses can pay more per employee and still come out even or ahead overall. Smart restructuring that trims the workforce — especially any "dead wood" that remains on the payroll — and pays more to those who remain will undoubtedly seem painful for business managers and owners. But the benefits will accrue for many years.

How Businesses Can Prepare

While many economists consider the high inflation of the early 2020s to be transitory, they don't expect it to go away tomorrow. According to the Federal Reserve Bank of Philadelphia, the aggregate view of 36 professional economic forecasters surveyed during the first quarter of 2022 was that inflation would average 5.5% in that quarter, as measured by the Consumer Price Index (CPI). They also predicted that the long-term inflation rate from 2022 to 2031 will be 2.5%, 25% above the Fed's 2% target. With more inflation on the horizon, it's important for businesses to be ready.

• Raise prices.

  As the cost of other goods rise, your business's prices will likely have to rise as well. Look at competitors; if their prices are well above yours, a price hike may not drive customers away, especially for essential goods. A gradual price hike over a longer period instead of an abrupt one may be easier for your customers to adjust to, so plan ahead. But be aware of the competition and don't lag behind with price increases; working capital becomes more expensive during inflation, so you don't want to absorb price increases from the input side.

• Restructure the workforce.

  As costs rise, many businesses are forced to lay off employees, drop full-time workers down to part-time and pay more to remaining staff. Do this thoughtfully, and you can turn that necessity into a strategic restructuring that increases your workforce's productivity while it builds employee loyalty and upskills the workforce. Incentivising advancement can keep your workforce competitive and skip the ramp-up time to train new employees to reach their peak efficiency. Similarly, a prepared business can see wage rises on the horizon and act while competitors drag their feet to try to shave off some short-term costs — something you can use to your advantage to bring their best workers over to your team and leave the other firms training a wave of rookies.

• Reevaluate the product portfolio.

  Just as the goal of workforce restructuring is higher employee productivity, the goal of product restructuring is higher margin efficiency. The aim here is to identify low-profit-margin products that your business can afford to live without so it can focus on higher-profit items. If rising costs cause a product to barely break even, consider retiring it from the portfolio and focusing on items that can more easily handle a cost increase. Productivity and efficiency are what enable an economy to emerge stronger from an inflationary period, and it's the same for each business within the economy.

• Borrow early at fixed interest rates.

  As banks raise interest rates to compensate for inflation, consider converting any adjustable-rate debts to fixed loans. As cash devalues, fixed-rate loans will become cheaper in terms of current dollars over time, but the cost of adjustable-rate loans can rise along with inflation. If a business has expansion plans in its foreseeable future, it could be wise to borrow the money to support those plans early in an inflationary cycle, especially if you expect high inflation to be around for an extended period. The cost of that borrowing will diminish over time, giving the business a potential competitive advantage.

• Diversify suppliers.

  It's always good business practice to have a diverse, resilient supply chain. Relying on only one supplier can create problems when prices rise or if the supplier experiences problems or delays. Multiple sources give a business more options, since prices and delays aren't always uniform in an industry. And when inflation hits, the business with multiple long-term supplier relationships has more bargaining power.

• Limit just-in-time supply chains.

  Though well-proven during stable times, this supply-chain strategy caused troubles for many manufacturing companies when supply chains were disrupted in early 2020. Keeping inventory at "just-enough" levels and restocking only when necessary can cause problems when supply and demand begins to fluctuate, sometimes wildly, under inflation. Having more stock on hand than is theoretically necessary can help prepare your business for increased demand and supply-issue delays. In times of accelerating inflation, it's in your business's interest to stock up early — if you can afford to do so — because the cost of that stock will continue to rise over time. This is similar to the thinking that drives consumers to stock up on certain key essential goods when they anticipate an extended inflationary period.

• General cost reductions.

  Examine where your costs are highest. Many businesses use inflationary periods as a chance to reevaluate all spending.

Prepare Your Business for Any Economic Condition With NetSuite Financial Management

Inflationary times bring so much uncertainty about the future that it's counterintuitive to think of them as a great time to reimagine your workforce with higher productivity or take on debt to finance expansion plans. But that's exactly what well-led businesses often do once they have a solid understanding of inflation's effects.

To pursue such inflation-era strategies, businesses must have accurate financial data and strong analytical tools that help them develop their plans. NetSuite Financial Management provides visibility into financial data and operational information that business leaders need to build what-if scenarios and forecasts. Real-time data and reporting dashboards allow business leaders to closely follow key trends and business results, and act quickly when the right moments present themselves.

Conclusion

Periods of inflation are often accompanied by worry and uncertainty. But a prepared business can get a head start on the steps needed to not only weather such a tumultuous period but come out stronger — more efficient and more productive — than they were before. As prices rise, so, too, should a firm's readiness to face the changing market head-on — and leave their competitors playing catch up.

Inflation Effect FAQs

What does inflation mean for businesses?

During extended periods of inflation, businesses face rising prices for the production inputs they need and the prospect of having to raise prices for customers. In worst-case scenarios, companies can get squeezed so hard between rising prices and customers' unwillingness to pay more that they go out of business. Smart businesses take the time to learn inflation's effects and make plans to work around or exploit them to improve their market position.

What are the effects of inflation?

In general, prices rise across the board during periods of inflation. That means businesses face rising costs for raw materials, workers and even rent, utilities and gasoline. Interest rates rise, so a business's cost of capital increases. Investment is sometimes stifled during inflation out of fear, uncertainty and doubt. Even foreign currency exchange rates are affected: The value of currency in a high-inflation country will fall relative to the currency of countries with low inflation.

Why is inflation bad for stocks?

High inflation tends to be bad for stocks because it raises borrowing costs as banks raise interest rates in response. Mild inflation, however, is good for stocks as it is a sign of a healthy, growing economy. The U.S.'s central bank works to maintain an annual inflation rate of around 2%.

How does inflation affect marketing?

When prices are rising throughout the entire economy and customers find their money buying less and less, excellent marketing can be a make-or-break proposition. Historically, strong brands have weathered inflation better than weaker ones. It's crucial for marketing to help customers understand the way inflation is affecting a business and what the company is doing to combat those effects on customers' behalf.

Is inflation good or bad for business?

Inflation can be good or bad depending on the business. An essential business with low competition and high loyalty will be less affected by rising prices, but any business will have to compensate for rising costs by raising prices, cutting costs or restructuring. Inflation also raises the cost to borrow money and, therefore, to expand a business, but it reduces the cost of existing debt.