The covid-19 pandemic has affected all aspects of life as we know it. As we are hopefully emerging from the worst of its social impacts, we are now faced with potentially crippling economic effects caused by the proliferating borrowing throughout the pandemic. In this article we will discuss inflation and what this could mean for businesses across the UK.
- What is inflation?
- What is the relationship between borrowing and inflation?
- How has covid-19 affected inflation?
- What does this mean for the economy as a whole?
- What does this mean for businesses?
What is inflation?
Inflation is the rate at which the price for goods and services increases. It is one of the most key measures of a country’s financial wellbeing; if there is inflation, goods are more expensive, and money does not go as far.
Inflation is expressed as a percentage increase or decrease over time. For example, if the inflation rate for a litre of diesel is 2%, a motorist will need to spend 2% more at the pump than they would 12 months earlier.
The danger with inflation comes when wages do not keep up with the rate of it’s increase. If this happens, consumers are charged more for goods whilst remaining on the same salary, meaning that consumer purchasing power and the standard of living falls.
However, small amounts of inflation can be good. When inflation is managed, it encourages consumers to buy products sooner and makes it easier for companies to increase their wages. Both factors are beneficial to the growth of the economy and therefore most countries’ central bank has an inflation target of between 2% and 2.5%. For the UK, the inflation target is 2% per annum.
What is the relationship between borrowing and inflation?
In effect, inflation is the decrease in purchasing power of a particular currency due to an oversupply of money in the monetary system. This happens when consumer and business demand for goods and services leads to an increase of borrowing to finance those purchases. However, this borrowing increases the supply of money floating in the system, meaning that there is an excess supply of money and a limited supply of goods/services. Hence, the bargaining power of a currency decreases.
How has covid-19 affected inflation?
The public health measures put in place to contain the spread of Covid-19, such as multiple lockdowns, have significantly reduced economic activity as firms and households are unable to produce and spend as they usually would. The knock-on effect from this is weaker global activity which further reduces export demand and causes a disruption to international supply chains. This has resulted in loss of revenue for firms and reduced household income for individuals.
The increased uncertainty caused by the above factors, lower confidence and a tightening in financial and credit conditions can amplify the initial fall in spending and production. This means that households have saved more as a precaution and some firms have made lay-offs and sold capital equipment. There has also been a substantial increase in government borrowing throughout the Pandemic to replace the wages of those who have been adversely affected (SEISS, Furlough, bounce-back loans etc.). While activity is beginning to recover now that social measures are lifting, there is without a doubt going to be longer-lasting effects on the economy.
In April alone, the annual UK inflation rate more than doubled to 1.5% (from 0.7% in March) as energy and clothing costs drove prices higher. Analysts predict that it will not be long before UK inflation surpasses the 2% target, but the Bank of England have announced that they are “certainly not hitting the panic button yet”.
What does this mean for the economy as a whole?
It’s safe to say that the pandemic has had a negative impact on much of the global economy. However, the severity of the long-term effects will be predicated on the consumer response to the easing of restrictions; It is less likely that firms will be able to generate increased demand through price cuts as consumers are less able and willing to spend, reducing the incentive to lower prices.
This means that the level of consumer confidence when coming out of lockdown will have a massive impact on the future of the economy.
During periods of weak demand, increased slack might not be fully reflected in lower costs for firms, if, (for example) some fixed costs such as rent remain unchanged. External cost pressures, such as movements in the exchange rate and commodity prices, will also influence inflation.
So far, there have been several significant changes to the state of the economy – below is a list of some of the main points:
- Monthly Gross Domestic Product (GDP) fell by 2.9% in January 2021, which is 9.0% below its February 2020 level.
- The fall in GDP was driven by a month-on-month decline of 3.5% in services in January 2021, which is 10.2% below its February 2020 level.
- Monthly production fell by 1.5% in January 2021, which is 5.0% below its February 2020 level.
- Monthly manufacturing fell by 2.3%, which is 5.7% below its February 2020 level.
- Monthly construction grew by 0.9%, but output is still 2.6% below its February 2020 level.
What does this mean for businesses?
Throughout the pandemic, we have seen some industries take a dive and other industries thrive. Businesses in the E-commerce, supermarket, digital entertainment and medical industries have done extremely well, but hospitality, tourism and fashion retail have taken massive hits.
Similar to how every industry was affected differently by the pandemic, the effects of inflation will vary depending on the business. For those who have taken out fixed loans, the significance of their loan payments dwindle as inflation rises. Additionally, during times of inflation, exports are cheaper against foreign competitors for businesses in commodity and overall goods trade/export, thanks to the falling value of the local currency.
What does this mean? Although it is unsure how every industry will be affected in the long-term, businesses need to learn to interact with the rest of the world, have smart control, fully digitalize, and conduct a spending review to analyse their options. Although this has been a very difficult time for many and the future seems unclear, just remember that Albert Einstein once said, “in the middle of difficulty lies opportunity” – you just need to identify what your individual opportunity is and leverage it to the best of your ability.
If you have any questions about the content in this article, please contact your usual Partner or Manager, or call us on 01942 242 245 and we will be happy to help.