We haven’t seen inflation for several years despite the extreme expansion of money supply. But most recently, there have been early signals that inflation may be around the corner. After years of high price stability, the annual U.S. consumer price index increased by 1.7 percent in the fourth quarter of 2016 and an increase of 2.3 percent is forecast for 2017. In Germany, we saw an increase of 1.7 percent in December 2016 and of 1.9 percent in January 2017. Several institutes predict a further increase for 2017 after years of zero or even negative inflation. The Wall Street Journal published an article “When it comes to inflation” in January. The leading German magazine Der Spiegel even devoted its title story to the coming inflation. There can be little doubt that we will see higher inflation rates in the near future, but nobody knows exactly when. Most likely a new inflationary round will come as a surprise. For price managers it is critical to understand what inflation means and to be prepared.
My grandfather used to tell me stories about life during the hyperinflation period in Germany in the 1920’s. The moment he would get some money, he would immediately rush off to the store and buy something. If he had waited for a few days – in some cases even a few hours – the value of his money, and with it his purchasing power, would have dropped precipitously. Hyperinflation is an extreme situation which still occurs today in emerging markets such as Zimbabwe or Venezuela. But most of us know inflation only in less severe forms. We generally associate the term ‘inflation’ with a continual rise in prices. But what are the effects of inflation? And how should you take inflation – both actual and anticipated – into account when you set your prices?
Inflation harms people who hold onto money and people who receive nominal, fixed payments. At the same time, inflation benefits people who owe money.  One can describe it as a form of redistribution from savers and creditors to debtors. These general effects are well known, but inflation also has deeper and more far-reaching effects.
The main cause of inflation is the increase of money supply. The winners in that scenario are people who can get their hands on newly issued money quickly. They can still buy goods and services at relatively low prices. The later you gain access to money, the more you lose, because you need to buy at higher prices. This is known as the “Cantillon effect”, named after the Irish economist Richard Cantillon (1680-1734).
Inflation also suppresses an important function of prices, namely their ability to signal the scarcity of goods. For consumers, price perceptions become distorted and confusing. It is hard to decide whether to hedge or hoard. For investors, inflation makes it much harder to recognize whether the prices they see reflect a real scarcity or a devaluation of the currency. This plundering money chases after certain forms of investment, causing prices to explode even though no underlying scarcity exists. This ‘bubble’ effect has occurred time and again, from the Dutch tulip craze of the 1600’s to the Internet bubble at the end of 20th century and the US real estate bubble in the first decade of this century. Currently we may see a bubble in stock prices, but nobody knows for sure. At some point the bubble bursts, prices collapse, and it takes a long time before prices begin to reflect true scarcity again.
Inflation is also a gigantic redistribution mechanism. Inflation allows the quick, the clever, and the debtors to take advantage of the slow, the naïve, and the creditors. It goes without saying that sovereign governments, which issue and hold large amounts of debt, are among the biggest beneficiaries of inflation. When inflation threatens, you need to strike quickly. That is the time to buy or borrow. The longer you wait, the more you will pay, allowing benefits to accrue to those who “bought low” and can now “sell high.” This is common sense. The art lies in seeing through the mass psychology at work and not interpreting the rising prices as a signal of scarcity.
The most common way to express inflation is the change in consumer prices, as measured by the consumer price index (CPI). The figure shows the change in the CPI in the U.S. from 1991 through October 2016, a quarter of a century. I have set the index at 100 for the year 1991, to make it easier to see the percentage changes.
Changes in the CPI of the U.S., indexed, 1991 through October 2016 (1991 = 100)
The upper curve shows the rise in price levels. In October 2016, the CPI was 77.2 percent higher than in 1991, which corresponds to an average annual inflation rate of 2.3 percent. If you have not increased prices in line with this curve, the real value of what you received in exchange for your goods and services has declined. You are among inflation’s victims. What you paid $100 for in 1991 would cost you $177.2 at the end of 2016 reflecting your loss in purchasing power.
The lower curve is the flipside of the upper curve. It shows the loss of purchasing power since 1991. In these 25 years the purchasing power of the U.S. dollar has declined by 43.6 percent. If we go all the way back to 1971 the decline is much greater, the purchasing power of the dollar declined by an incredible 83.2 percent.
Why do I pick 1971, which seems like an arbitrary year? That is the year the gold standard under the Bretton Woods system was abandoned by President Nixon, a move which opened the door to continuing inflation. You will hear politicians refer to an annualized inflation rate of around 2 percent as “modest.” Most conservative central bankers consider 2 percent per year or a little more to be within an acceptable range. The cumulative effect, however, is enormous and destructive for inflation’s victims, who get dispossessed as their nominal dollars buy them less and less. The dollar has lost more than 40 percent of its value in just a quarter century and over 80 percent of its value in the last 45 years.
Relative to the price of gold the loss is even higher. On January 16, 2017 the price of one ounce of gold was $1,202.51. That’s what you would have had to pay to get one ounce of the precious metal. Before August 15, 1971 the same amount of dollars would have bought you 37.1 ounces of gold. Thus, the loss of the dollar’s value in gold terms since 1971 is 97 percent. Per January 2017 you would have to pay $44,613 to buy 37.1 ounces of gold.
I interpret the lack of discussion and attention on this creeping inflation as tacit acceptance of it, or perhaps resignation to it. Most people take this development for granted. The only effective way to stop it would be to reestablish the gold standard. But such an action would remove some very powerful tools from politicians’ toolboxes, which is why it is unlikely to happen. Unstable money which loses its value – whether slowly or quickly – will remain a fact of life in modern economies.
The high levels of government debt, combined with the relatively loose monetary policies since the Great Recession began, mean that a sharp increase in the inflation rate is unavoidable in the future. The only question is when it will come. Many companies will face do-or-die decisions when that happens. How they manage their prices will make a critical difference. In emerging markets, we already see increasing rates of inflation. Maybe we can learn something from the history of Brazil, a country that had very high inflation rates over several decades
Here is a case from one of our projects in the hyperinflation 1980s. One of the world’s largest pharmaceutical companies needed to make a high-stakes decision in Brazil, where out-of-control inflation reached a rate of several hundred percent per year. Their biggest product was an over-the-counter pain reliever. The company considered hyperinflation an opportunity to increase market share through a combination of lower relative prices and more aggressive advertising. And that is exactly what they implemented. They intentionally raised prices below the rate of inflation, to make their product cheaper relative to the competition. They also increased their spending on advertising.
Management’s confidence in these moves – and their odds of success – seemed to increase when the competitors continued to raise their prices at the rate of inflation or above. This widened the price gap in the favor of our client even more than they originally anticipated.
It turned out that this strategy was counterproductive. Why didn’t it work? What happens to price perception during periods of inflation? Signals become confusing due to the constant flux of price changes. In Brazil at that time, the consumers did not recognize the price advantage that the pharma company had worked so hard to establish. It got lost in the noise, as did the increased advertising.
I recommended that the company not only pull back from its current tactics, but implement the exact opposite approach. They should raise prices at least at the level of inflation (or even a bit more) and cut back on advertising. Profits improved considerably with this new tactic, and market share barely changed as customers remained loyal to the brand.
I learned two lessons from this case. First, an attempt to establish a price advantage will not work unless customers notice and understand it. Price signals are harder to convey clearly in inflationary periods. Second, under inflationary conditions I strongly recommend a series of small, regular price increases instead of a few significant changes. The series of small changes allows you to keep pace and to avoid the need to overcompensate for lost time and money with a big price adjustment later. You should start these increases and establish the rhythm as early as possible when inflation sets in or even when it looms.
¹Prof. Dr. Dr. h.c. mult. Hermann Simon is founder and honorary chairman of Simon-Kucher & Partners.
²The Wall Street Journal, January 10, 2017.
³Deutsche Angst: Inflation? Nur ein Phantom, Der Spiegel, January 13, 2017.
⁴Thorsten Polleit, Der Fluch des Papiergeldes, München: Finanzbuch-Verlag 2011, pp. 17-20.
⁵Richard Cantillon, Essai sur la nature du commerce general; 1755, in English: An Essai on Economic Theory, Auburn (Alabama): Ludwig von Mises-Institute 2010.
⁶Inflation Worries Mount, The Wall Street Journal, February 12, 2014