Inflation: More Than Supply Chain And Macroeconomic Issues

An entrepreneur and investor. Co-founder at USEReady. attending Owner/President Management - Leadership Program at Harvard Business School

When the Covid-19 pandemic hit, governments worldwide struggled to keep their economies afloat amid nationwide lockdowns, the closure of businesses and social distancing regulations. Since many countries have reopened their societies, some economies have recovered. However, now, months later, many of these countries are grappling with high inflation rates. This rise in inflation rates is due to many reasons that policy and finance experts have been focusing on, including supply chain issues and short-term macroeconomic trends. However, fewer analysts have assessed business psychology's role in spurring the current economic environment.

Over the past several months, many economies that have reopened have posted stronger earnings, although labor and material costs are higher. This is because of several reasons. First, the cost of credit is currently lower than it was before the pandemic began. Second, many businesses are saving significant funds as they transition to hybrid or remote work environments. For example, in New York City, rent for once-coveted office and retail spaces has dropped a staggering 30-50%. Many companies that intended to invest in expanding their office spaces pre-pandemic have now put those plans on hold. Additionally, many companies are saving money as business travel, client entertainment events and conferences have decreased. Third, I've observed that many companies remain timid about investing in innovation and designing and launching new product lines in uncertain markets.

Fourth, the cost of labor is high and gradually increasing due to an ongoing labor shortage. As a result, many businesses are operating at decreased workforce capacity. Although many companies are beginning to compensate their workers more to retain talent, the overall cost of doing business is still lower due to higher productivity and a labor shortage. Fifth, according to my company's data, pre-pandemic, the utilization rates of service companies were between 80% and 85%. Today, these rates have increased markedly to 95% or higher. This additional revenue is contributing directly to the bottom line of these organizations. Lastly, numerous government subsidy and tax credit programs have altered spending behaviors. As a result of these factors, there is a significant amount of excess money in the economic system, which has inflated the value of assets and fostered demand. Therefore, despite higher labor and material costs, there are fewer defaults and bankruptcies.

The pandemic is a harrowing social and economic experience for people around the world. However, it has delivered certain benefits to consumers. Today, consumers in many nations have benefited significantly from the fiscal and monetary policies governments introduced to mitigate the economic fallout of the coronavirus. Additionally, many workers began receiving higher wages, saving more and prospering with lower interest rates. In this environment, businesses that have not been able to improve their unit margins have been able to pass on increased labor and material costs to consumers, who have demonstrated willingness to pay more for goods and services. Businesses have, therefore, been able to sell more units and obtain predictable revenue growth. However, while an increase in sales under price inflation may increase revenue, this may not directly correlate to growth. 

Many policy and economic experts have conducted in-depth evaluations of the supply chain and macroeconomic issues contributing to rising inflation rates in post-reopening economies. However, fewer analysts have evaluated the role that business owner psychology plays in contributing to inflation rates. 

Consider a manufacturer who generated $100 million in revenue with a 10% or $10 million net margin pre-pandemic. Post-pandemic the revenues have declined to $70 million with a net margin of between 15-20% and still make $10 million or more in net margins in the current economy. This is because, despite supply chain issues, material shortages and price increases persisting, the manufacturer benefits from government subsidies and has a higher productivity rate, lower cost of working capital, decreased investment in expansion and innovation and reduced business costs. As a result, the manufacturer's profitability is higher. This is visible across many sectors, including the manufacturing, services and high technology sectors. 

However, businesses that opt to maintain lower revenues with higher margins inadvertently exacerbate ongoing supply chain issues. Currently, trading multiples are pushing companies to maintain high profitability levels and predictable revenue levels. As a result, companies are investing less in innovation and avoiding over-producing goods as this would force them to provide them at a discount. In doing this, companies are instead opting to charge a premium for their products and services. This forced slowdown and decision to safeguard their economic interests by small, medium and large companies across industries hinders efforts to solve the ongoing supply chain issues. For example, many new and used car dealerships, car manufacturers and car component manufacturers prosper significantly in the current economic environment. But, if these entities all increase the supply of cars, their profitability and market value will drop drastically, and they will have to sell their inventory at a discount instead of using pricing power to charge consumers higher prices. 

As nations struggle to manage rising inflation rates, policy and economic experts are correct in evaluating the role of supply chain and macroeconomic issues in contributing to this problem. However, these analysts must also consider the role that business psychology plays in exacerbating this issue. If businesses continue to maximize their profitability, prioritize predictable revenue growth, tighten their supply sides, maintain high stock prices, avoid scaling production and innovation and evade risking competition and price stability, I believe they will continue to hinder economic growth and undermine efforts to address growing inflation rates.

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