Inflation and firms

Inflation has hit an all-time low in the UK. This is good news for wages and house prices, but what does it really mean for small businesses?

Inflation was down to 1.6 per cent in March, its lowest since 2009. But it is still important that small businesses remain mindful of its effects. Even a small increase could hurt capital expenditure and increase the cost of production for goods businesses.

Controlled inflation is seen as healthy stimulus for the economy as a whole, but it can be a challenging beast to keep in check. The Government’s target inflation rate is set at 2pc, and anything over this figure can reduce the value of money, both for individuals and businesses.

Larger corporations are generally better positioned to bear the brunt of inflation, as it can be offset by savings generated by economies of scale. Small firms, however, often take a direct hit on margin.

High inflation can also have unexpected side effects: it can negatively affect currency exchange rates and bring about an export slump: rising prices in the UK make goods and services uncompetitive on a global scale.

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Impact of inflation on firms

Some of the costs of inflation for firms

• Menu costs. These are the costs of changing price lists. If inflation is high, then firms will have to update prices more regularly. There are costs involved in this. For firms like Pound / Dollar shops, this high inflation could be particularly damaging because it becomes harder to find goods which can be sold for a Pound.
  • However modern technology makes changing prices much easier than before. These days, you don’t need to change prices manually, but can update bar codes and this is less time consuming.
• Wage Inflation. Unexpected inflation may lead to the necessity of renegotiating wage deals with workers. However, these wage rises may be expensive for the firm because they cannot afford them.
• Uncertainty and confusion. If inflation is higher than expected, then the costs of investing will be changing frequently. This makes firms less willing to invest because they are uncertain over future costs, wages and future demand This is particularly a problem with unexpected cost push inflation raising the price of raw material costs. This is perhaps the biggest cost of inflation for firms – high inflation creates uncertainty and can lead to lower growth.
• International competitiveness. If UK inflation is higher than other countries, then this will make UK firms less competitive than international competitors; this is important for exporters.
• A higher inflation rate than our competitors will also lead to a depreciation in the exchange rate; this will help to restore competitiveness, but at the expense of more expensive imports and a decline in living standards.

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Impact of inflation on firms

Firms generally prefer inflation to be low and stable. If inflation rise above 3 or 4%, firms may see a rise in costs and uncertainty. In some circumstances, high inflation can negatively affect a firms profits. However, it is worth pointing out that deflation (falling prices) could also be very damaging for economic growth and firms.

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