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Getting a Handle on Inflation Risk

I’m willing to bet that the majority of Savvy Director readers are not economists or financial experts. And neither am I.
 
But a recent comment from DirectorPrep co-founder Dave Jaworski – following one of his board meetings – got us thinking about what the board needs to know about inflation, and what kind of questions might a director want to ask.
 
So, this week’s blog post will delve into how savvy board directors are thinking about inflation. But first, the big picture.

 

Inflation - Transitory or Persistent?

As board directors, we should have a basic understanding of how the economy works, and especially how economic realities impact the organizations we serve, whether for-profit or non-profit. Every organization – regardless of where it operates or what sector it’s in – is subject to fluctuations in the economy. And since our board deliberations are usually future-oriented, we need to consider not just the current state of the economy, but the outlook for the future.
 
There’s no doubt the COVID-19 pandemic has caused global economic disruption. Inflation is one of the many shocks to the economy that we are living through.
 
Simply put, inflation is a general rise in prices. Right now, what has some directors concerned is the possibility of significant inflation on the horizon. After all, most of us are already experiencing inflation in our personal lives – a trip to the grocery store or a gas tank fill-up confirms that inflation is alive and well.
 
So, what does the threat of inflation mean to the organizations we serve, and what can we do about it? To better address those questions, it would be helpful to know how long the current inflationary period might last – will it be transitory or persistent?
 
The case for transitory inflation rests on the arguments that, since prices fell sharply in the early days of the pandemic, much of what we are now seeing is catch-up growth; and that once supply chain bottlenecks clear up, supply will catch up with demand.
 
The arguments for persistent inflation include facts such as measures of core inflation (stripping out the most volatile components) are increasing; household and business expectations of inflation are increasing; demand pressures have increased as households are ready to start buying again; sharp increases in energy and commodity prices have given businesses an incentive to raise their prices; and labor shortages are putting upward pressures on wages.
 
Given all this, some – but by no means all - experts feel that the argument that inflation is becoming persistent is strong.

 

The Impact of Inflation

From a board director’s perspective, how inflation might affect your organization – and how to prepare - depends on the sector where it operates and on its business model. Some businesses are able to pass along the increased costs to consumers in the form of higher prices. However, there can be a time lag as inventories are cleared out or where long-term fixed-price contracts are in place. And for some, regulatory authorities limit their ability to pass on their cost increases.
 
As households have less money available for discretionary spending, they begin to cut back on expenses that they view as unnecessary, so producers of luxury goods, or services such as sports or entertainment, may be at higher risk. And when it comes to the non-profit sector, people may cut back on their charitable giving, resulting in a funding shortfall for all sorts of charities, foundations and other non-profits.
 
If it looks like inflation is going to become a problem, central banks will start to raise interest rates to try to get inflation under control. In fact, financial experts are already forecasting a series of interest hikes over the next year or so.
 
Higher interest rates may affect your organization in ways you haven’t thought about. Financial services organizations like banks generally benefit from higher interest rates, and an organization’s investment income as well as the value of their investment portfolio would be affected. If your organization has an investment portfolio, or there’s a defined benefit pension plan on the balance sheet, there’s both upside and downside risk to be considered.
 
Interest rates also affect an organization’s capital spending if borrowing is part of the plan. With historically low interest rates, financing has been cheap over the last few years. But upcoming increases is borrowing costs can cause organizations to either defer capital spending, or to get started right away to lock in today’s low rates. What kinds of questions might boards be asking?
 
As for government-funded organizations, they may see their core funding under severe pressure – even more than usual – as governments try to get their costs under control. Their CEOs have to figure this out too.
 
And then there’s wage inflation – the demand for higher wages to keep up with prices. Higher wage demands impact every sector, but not necessarily to the same extent. One study found that, while all workers are demanding higher wages, those who must work from their job site are demanding much higher wages than those who can work from home.
 
Where feasible, organizations might choose to invest in automation to reduce their reliance on employees – but of course that’s not always possible. And when it comes to compensation, a director’s thoughts naturally turn to executive compensation. What will be the affect of inflation on total compensation for their CEO and the rest of the executive team?

 

What Directors Are Thinking About

I reached out to our DirectorPrep network of directors – people whose organizations represent a cross-section of sectors and business models - to find out how their boards are dealing with inflation risk.
 
It seems that, at many organizations, inflation is not high on the radar right now. They find that their boards are consumed with other issues. Where inflation is being discussed, for the most part it’s part of a larger discussion about finances. Directors indicated they would expect to see more discussion of inflation as budget season rolls around, when they start to see cost increases integrated into management’s spending proposals.
 
Having said that, some are keenly aware of current inflationary pressures, especially those who are exposed to rapidly increasing supply chain costs. As these directors commented:
 
“I appreciate different industries may be seeing differing rates of increase, but it is something the boards should get a handle on. No question anyone whose supply chain requires goods delivered by ocean freight have seen huge increases in shipping costs. I have seen examples of shipping costs for containers from the far east increasing by more than 300%. Add to this what is likely to be an overall shortage in the labor market which will drive up local costs, and a company’s ability to recover these increases may be in doubt.”
 
“Inflation discussions are absolutely happening virtually around each planning table I see. It is really still a bit early in understanding of where this is going and what it means broadly, or for our sector specifically. The supply chains are upside down with demand for specific supplies outstripping capacity whether chips, manufacturing capacity (or even Chinese electrical grid issues) or simply issues with blockages at ports … and the impact on secondary costs (fuel for example).”
 
In the public sector, directors indicated a focus on how inflation might impact capital projects:
 
“I’m thinking about our capital budget – we have a substantial plan for investment pending – we have avoided debt over the past 5-6 years – but borrowing rates were never better. Inflation may increase our debt costs if we chose to go that way.”
 
“The big challenges are longer term capital expenditure planning due to the vast swings in pricing for various materials and components. So, the question is how to determine a good budget price for future periods - especially for those projects that span several years.”

 

Questions for The Savvy Director

Many directors contributed ideas for inflation-related questions that a Savvy Director could raise around the board table.
 
“The best questions are those that are more directly related to strategy and its application for this company in this uncertain environment, and that focus management on the critical versus chasing answers specific to inflation itself.”

 

 
My sincere thanks for the following insightful questions suggested by our DirectorPrep network (supplemented by a few found in the course of our research on the topic):

Strategy

  • How does our strategy incorporate economic shock absorbers that enable us to remain resilient?
  • Has management done an in-depth analysis of the situation and built a strategy for mitigation? What are those mitigation strategies?
  • How do our business strategies take into consideration the risk of increased inflation?
  • Do we have inflation on our risk register? How have we rated it? What mitigation is in place?
  • Do our competitors have the same inflation exposure as we do?
  • Should we revisit previous policy decisions that relied on the assumption of low inflation?
  • Has the company previously operated in an inflationary environment and, if so, how did it fare?
  • Do we understand our sensitivity level to increases in inflation?
  • Are inflationary adjustments required now in order for us to reach our long-term goals?
  • Are there unexpected opportunities due to inflation? How might we take advantage?
  • Do we have products that are at a higher risk of inflation versus others in our portfolio?
  • If we respond to inflation in one market, would that impact us in another market where the impact of inflation might not be felt to the same extent?
  • How will we be communicating (if at all) on price inflation pressure?

Inflation Expectations

  • What are our expectations in terms of duration? What if we’re wrong?
  • How much of the inflationary pressure is related to the supply chain issue? Do we expect it to be temporary or long-lasting? How are we adjusting?

Pass Through

  • What is our pricing power and our suppliers' pricing power?
  • How will our customers be impacted from a pricing or supply perspective?
  • Which cost increases can be passed on via price increases and which do we have to absorb, at least for now, because of contract restrictions? What will the market bear?
  • Have we been able to increase our prices enough to maintain an adequate profit margin?
  • If we can’t negotiate price increases, what actions might we take to reduce the impact of inflation to help maintain our margins?
  • What is our risk of input cost inflation in the current year? How much of that risk have we already experienced, and how much have we successfully defended against or passed through?
  • What’s the remainder of risk for this year? How are we addressing it and how are we situated to recoup margin?

Labor Costs

  • How does inflation affect our payroll, costs of attracting and retaining staff, and training, development and incentives?
  • What impact might inflation have on our ability to compensate and retain talent?
  • Are we planning on increasing wages in response to rising inflation, especially in light of the shortage of workers?
  • Will we tie wage increases to the rate of inflation to ensure we maintain fair salary and benefit levels to attract and retain staff?

Finance and Investments

  • Will our access to capital be restricted as a result of rising interest rates?
  • What will be the impact on our costs of borrowing? Will we be able to continue to service our debts?
  • If interest rates rise, how quickly can we respond to interest rate disparities between our assets and liabilities?
  • How are our investments likely to behave if higher inflation is prolonged?
  • How exposed is our investment portfolio to inflation risk? Should we be taking steps to mitigate the risk?

 

Your takeaways:

  • No matter your seat, make sure you are paying attention to economic indicators – both lagging and leading – to better understand the environment that impacts your organization.
  • Inflation is a reality right now, but there is disagreement as to whether it is transitory or will last a long time.
  • Persistent inflation has wide-ranging impacts on organizations, but the nature of those impacts differs according to your industry sector and business model.
  • Starting to ask questions in the boardroom is one of the best ways to make sure that your board and the management team are taking inflation risk seriously.

 

Resources:

 

Leave a comment below to get in on the conversation.
 
Thank you.
 
Scott
 
Scott Baldwin is a certified corporate director (ICD.D) and co-founder of DirectorPrep.com – an online hub with hundreds of guideline questions and resources to help prepare for your next board meeting.
 
 
Share Your Insight: We’d love to hear your thoughts about inflation risk.

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