🔒Is your business ready to deal with inflation?

For the past two years, labor shortages and disruptions in the supply chain have become part of everyday business management, and have taken a toll on how businesses and organizations plan for their financial well-being.

Over the past several months, businesses have had to add high inflation to the list of challenges and try to figure out how the Federal Reserve’s response may impact their decision-making process as they manage their finances.

To help ease inflationary pressures, the Fed ended its quantitative easing program in March, and raised the key federal funds rate by 0.25% in March and 0.50% in May. Thus, 2022 marks the start of another “Fed-tightening cycle,” which brings questions with it:

• How far will the Federal Reserve need to raise interest rates to bring inflation back down to its 2% target?
• Will raising interest rates eventually cause the economy to slip into a recession, or can the Fed engineer an economic soft landing?
• What will this mean for businesses and organizations, and how will it impact short- and long-term planning?

The short answer to all is, no one knows, not even the Fed. The U.S. economy is dynamic and complex, and the Fed is data-driven — its future actions will be based on data that stems from the decisions of millions of consumers, investors, and business owners. Still, there are some insights we can gain from past Fed-tightening cycles.

Act with caution — all is not as it may seem

The beginning of a Fed-tightening cycle can be marked by the opposite of what the Fed intends. Specifically, the Fed is trying to slow down the economy, but rational consumers understand that it’s cheaper to borrow and buy now, before interest rates go up and residual inflationary pressures drive prices even higher.

These are unintended but logical consequences.

The net effect is that demand is pulled forward and the economy may appear stronger than it otherwise would. On the flip side, future demand is now lessened, thus opening the possibility of a sharper slowdown in the future.

All of this helps to explain why economists believe it is difficult for the Fed to engineer a “soft landing.”

Stress-test your business metrics

As businesses and organizations adjust and potentially recalibrate financial planning, there is no one-size-fits-all approach. Instead, they need to understand how a Fed-tightening cycle may specifically impact them.

For example, nondiscretionary consumer purchases are less likely to be impacted than discretionary capital expenditures. Consider the elasticity of client demand relative to rising interest rates and a slowing economy, and then examine the results of a stress test to understand how it may impact revenue and cost structure.

How will this impact your business?

As the Fed-tightening cycle continues to drain liquidity from the economy, cash management could become paramount. If the Fed drains too little liquidity, inflation will persist. If the Fed overshoots and drains too much liquidity, a “liquidity squeeze” will occur.

Therefore, businesses need to carefully consider how much cash is appropriate to hold on their balance sheet. Too much cash will drag down earnings or sustainability, while too little cash could result in a cash crunch or even insolvency. What’s more, increased borrowings will impact your balance sheet health.

How will interest rates impact your pricing or future expansion efforts? And ultimately, how will the future economic environment impact consumer demand and ability to pay?

As the Fed works through this 40-year high in inflation, businesses need to be examining these areas and asking the right questions to help promote growth and sustainability.

Walker Wilkerson is managing principal of national assurance and Steven Jones is director of investment strategy for CLA, an accounting, auditing and professional services firm with offices throughout Connecticut.