Inflation will impact your organization – are you ready? : 2022 : Articles : Resources : CLA (CliftonLarsonAllen)

key ideas

  • To help ease inflationary pressures, the US Federal Reserve (Fed) ended its quantitative easing program and raised the key federal funds rate by 0.25% in March and a further 0.50% in March. May, thus initiating a “Fed tightening cycle”.
  • Stress testing your trade metrics can help you understand how the Fed’s tightening cycle may be impacting your organization’s revenue and cost structure.
  • As the Fed’s tightening cycle continues to drain cash from the economy, think carefully about how much cash to keep on your balance sheet.

The tightening cycle has begun

Over the past two years, labor shortages and supply chain disruptions have become part of the day-to-day running of businesses. Now companies need to add high inflation to the list of challenges and try to understand how the Fed’s response may impact their decision-making process.

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. (Federal Reserve) So 2022 marks the start of another “Fed Tightening Cycle”. As with all Fed tightening cycles, the key questions are:

  • How far will the Fed need to raise interest rates to bring inflation back to its 2% target?
  • Will raising interest rates eventually push the economy into a recession, or can the Fed stage an economic “soft landing”?

The short answer is that no one knows, not even the Fed. The US economy is dynamic and complex, and the Fed is “data driven”. In other words, future Fed actions will be based on data from the decisions of millions of consumers, investors and business owners. Nonetheless, we can learn from past Fed tightening cycles.

Proceed with caution – all is not as it may seem

The start of a Fed tightening cycle may be marked by the opposite of what the Fed intends to do. Specifically, the Fed is trying to slow the economy, but rational consumers understand that it is cheaper to borrow and buy now, before interest rates rise and residual inflationary pressures push even higher price.

The net effect is that demand is pulled forward and the economy may appear stronger than it otherwise would be. On the other hand, future demand is now reduced, opening up the possibility of a sharper downturn in the future. All of this helps explain why economists think it’s difficult for the Fed to stage a “soft landing.”

Test your business indicators under stress

There is no “one size fits all” approach. Instead, every organization needs to understand how a Fed tightening cycle can affect them specifically.

For example, non-discretionary consumer purchases are less likely to be affected than discretionary capital spending. Examine the elasticity of customer demand to rising interest rates and a slowing economy, then examine the results of a stress test to understand its impact on revenue and cost structure.

What impact will this have on your business?

As the Fed’s 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 goes over limits and drains too much cash, a “cash squeeze” will occur.

Therefore, carefully consider how much money to hold on your balance sheet. Too much cash will weigh on earnings or sustainability, while too little cash could lead to a “cash shortage” or even insolvency. Increased borrowing will impact the health of your balance sheet. How will interest rates impact your prices or future expansion efforts? And finally, what will be the impact of the future economic environment on consumer demand and ability to pay?

How can we help you

Whether you’re looking to grow or trying to understand how each of these elements will affect your profitability or sustainability, CLA can help. We bring deep industry knowledge and experience to every conversation to know and help you.

Our CLA Intuition financial modeling process can help you visualize real-time scenarios and allow you to combine historical information with the impact of higher interest rates and fluctuating consumer demand. Contact your CLA advisor today to learn more.

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