Does history provide management lessons?
We have been lucky in the past decade (indeed for thirty years) to be blessed with consistent levels of inflation, and subsequently stable (and very low) interest rates. This has allowed for low-cost borrowing and prevented the value of money diminishing at a rapid rate. It has not always been the case in the UK or indeed around the world. Venezuela and Zimbabwe are examples of where inflation has been excessively high, or “hyper”, where wages being received on a Friday were worthless by the Monday morning. In the UK in the 1980s, inflation reached 20%, which is difficult to comprehend from recent history.
Inflation history
Inflation has been below 5% for thirty years, but the previous twenty years were turbulent, almost reaching 25% in 1975. The rise coincided with negotiations to join the EU from 1969 and didn’t stabilise until the European Economic Community became the European Union with the conclusion of the Maastricht Treaty in 1992, immediately after ‘Black Wednesday’ when the UK ended its disastrous flirtation with the Exchange Rate Mechanism of the European Monetary System.
Ignoring the specific reasons, just think about the underlying political turbulence driving economic turbulence and, tellingly, the fact that successive UK Governments failed to stem the problems until Maastricht.
Brexit, the recent pandemic, and Ukraine are turbulence factors the likes of which have been missing from our past thirty years and make it exceedingly difficult to predict ongoing economic consequences. What we do know is that the short to medium term economic future looks unpredictable, and inflation reaching 7% at the turn of this fiscal year was not a great start.
Good news or bad?
Inflation is not bad news for all business sectors as it can drive profitability through increasing margins or even capital value, as it did in the 1980s when asset stripping produced huge bonuses for business acquirors disposing of unproductive assets and turned poor business investments into vast wealth for many individuals. Those same individuals gained from rising interest rates at that time and their successors no doubt look forward to increasing investment income today as rates begin to increase.
One figure fits all?
There are subtleties about inflation that are worthy of deeper consideration in financial forecasting and business planning generally.
As we know the Government publishes the Consumer Price Index (“CPI”) inflation figures monthly based upon inflation across a basket of circa 700 consumer goods and services, but how does this impact people?
Obviously, the shopping baskets in well to do areas are different to those in impoverished areas, and a published CPI of 10% may well reflect neither. It is quite possible for some to experience hyper-inflation due to their lifestyle, whilst others experience little or none. Analysis from the Institute for Fiscal Studies suggests the increase in gas and electricity bills expected this October could lead to average annual inflation rates of as high as 14% for the poorest 10th of households, compared with 8% for the richest. This is because lower-income families spend a larger share of their budgets on basics such as food and energy than richer households
There is some selective continued use of RPI (with its usually higher rate) by Government for taxes, bonds and benefits but let us ignore these complicating factors and the breaking of the pensions triple lock for now.
Suffice to say that assuming an individual is experiencing inflation equivalent to CPI (or even RPI, RPIX, CPIH, etc) would be misleading.
Are we safer in Britain?
Another major influencer of inflation, particularly during turbulent times, is relative currency value.
When a currency moves down in value against another, Citizens of that country will experience an increase in inflation rates compared to the country with the upward value movement.
Obviously sterling value versus the Euro and Dollar are pertinent here, particularly when trade link changes leave € and $ countries with reduced demand for sterling, leading to its value reduction and open to speculative attacks, as happened in the 1970s and 1980s.
Why, we may ask, should we rely upon CPI for forecasting with such vagaries?
Inflation-proofing
From a corporate perspective, the demand for inflation-proof businesses rises with inflation, having been largely ignored for the past thirty years of low inflation by all but the most insightful investors. Inflation-proof businesses are those that do not experience major operating costs with regular price rises that cannot be passed on to customers without impacting sales. Professional services businesses across the City of London have often proved to be inflation proof (but not competition-proof), whereas industries reliant upon outsourced materials can be subject to uncontrollable inflationary pressures that only some can counter short term with complex forward contacts and other hedging arrangements to lockdown immediate profitability.
In projecting future cash flows during turbulent times, as some believe may now be upon us, it is essential to understand the potential impact of inflation on costs and revenues.
In my current field of social housing, we have a fixed CPI+1% rent limit until 2025 - a firm forecasting start, but ambiguities begin with the ability of tenants to meet rent and other housing cost responsibilities, which pressures duties of care and services as well as costs. New build and maintenance material costs are also less predictable, with the only certainty being that they will not increase homogeneously with CPI. Right-to Buy and other regulatory changes could bring further cost pressures.
Cause and response?
The key factors that contribute to raw material cost inflation and shortages are manifold, but post Brexit, COVID and Ukraine war factors make predictions of availability and prices particularly difficult at this time. This is where the age-old forecasting practices of contingency costs and scenario planning come into play.
The only certainty about a single projection of future cash flows is that it will always prove to be wrong. The alternative is a well thought out group of scenarios with firm bases and assumptions that allow tweaks to future financial tactics and strategies as results unfold, and as those varied bases and assumptions are tested or proven. In large organisations, straightforward Treasury management may prove insufficient, without sensible projection monitoring becoming an everyday activity rather than a cursory once-a-year practice during budget setting.
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