What retailers need to know about inflation: Part 1

This is the first instalment of a two-part series from James Taylor and the Particular Audience team discussing what retailers need to know about inflation. 

With money supply ballooning, energy prices surging and increases in the consumer price index, inflation is beginning to bite. First felt by corporations in 2021 and quickly passed onto the consumer, inflation was initially touted as ‘transitory’.

But following a decade of printing money and extremely low interest rates, as well as helicopter stimulus born out of a pandemic response and ongoing global supply chain shocks, inflation has persisted and increased.

Retail is alive and well, with digital marketplaces absorbing the cash from brick-and-mortar lockdowns of the last two years, but the erosion of money purchasing power and with interest rates expected to spike, inflation will have an impact on consumer confidence and margins in retail and e-commerce businesses. 

A natural way to think about inflation is not that things get more expensive, but that the value of the currency has dropped. Retailers purchase goods and (ideally) sell them for a profit. They need low prices and hungry customers.

Consumers need some money to spend on goods, and in many retail categories they need enough surplus cash (and confidence) to afford discretionary spending.

Inflation is dissolving the value of people’s savings, but does that mean they are likely to spend more? Costs are going up, and consumer appetites are uncertain. Some retail categories such as staple fast-moving consumer goods (FMCG) products have tremendous pricing power and the ability to raise prices without impacting demand — but others are less fortunate.

Generally, we don’t notice inflation when it is kept in check. New technology costs more than older technology did, wages increase and investments do well. We seldom notice when a chocolate bar costs $1.30 as opposed to $1.

But extreme inflation has a noticeable effect.

During inflationary periods holders of cash lose out. Inflation is particularly difficult for workers on fixed incomes — as prices rise, the value of their money falls and they find it harder to make ends meet. For this reason, in inflationary periods lower income households will spend a larger proportion of their wages on necessities due to price rises in food, housing and utilities like gas, leaving less money for discretionary spending. Higher income households may also find themselves with less disposable income unless wages rise enough to keep pace with inflation. 

FMCG and discretionary items are treated very differently during periods of inflation. Generally FMCG producers have upward pricing power to compensate for inflation without harming sales; discretionary items however do not and their margins are more likely to dip as upward pricing harms sales, creating a lose-lose environment. 

Can retailers afford to lift prices?

Still reeling from direct and indirect effects of COVID-19 — primary among these rising material, production and transport costs and labour shortages — certain retailers are facing significant margin squeezes from increased costs. The question now for retailers is: how much can they lift prices without losing sales?

Passing costs on to consumers is always a difficult call, even when your competitors are also facing margin squeezes. Some retailers can afford to lift prices more than others, but it depends on what you’re selling and how price sensitive your customers are. 

To understand how responsive demand for a good or service is to a change in real income, we can look to the concept of ‘income elasticity of demand’. Think of ‘elasticity’ as ‘sensitivity’. You won’t be sensitive to price change if it doesn’t take a big portion of your income. 

During periods of inflation, consumers tolerate price rises on necessity products, such as staple foods (or non-essential products that are nevertheless treated like necessities such booze, chocolate bars or cigarettes); however, when it comes to larger purchases in verticals such as white goods, they may reduce or postpone spending on, for example, fridges or washing machines, if there is a noticeable price hike. This is especially true of lower and middle income consumers, for these consumers, given the ‘necessity’ nature of some of these devices sales are likely to continue, we can only expect lower price options to perform better than the middle.

By the same logic, higher income consumers who are less sensitive to price changes that occur during periods of inflation are less likely to withhold consumption. Goods in luxury verticals — which enjoy the additional advantage of strong consumer loyalty irrespective of price — are less likely to be affected by price changes, and may even benefit from the perceived ‘exclusivity’ of increased price (there are certain goods that become more desirable as they become more expensive, these are referred to as ‘Giffen Goods’). 

Outside of necessity items, optional spending categories are likely to take a hit.

Consumers get stung by inflation and they become worse off, which poses a demand risk to retail.

If a retailer’s inventory is a total necessity, is not a high consideration purchase, and that retailer is part of a duopoly or monopoly, then they will do relatively well as they are most able to raise their own prices. Retailers are going to see their cost bases go up — even Visa and Mastercard are increasing their take.

The more competitive a retailer’s vertical, and the less necessary the product being sold, the worse a retailer will fare during inflationary periods. With this in mind, retailers must make careful choices when raising prices depending on the vertical they operate in, and even treat segments within their vertical with some difference.

We are in risky territory, and retail businesses need to prepare for all outcomes immediately.

This is an edited extract from an essay that was first published on Medium.