Just as CFOs are guiding their companies out of the pandemic, they face a new peril to their profits — rising inflation.

The Federal Reserve’s preferred inflation measure — the core personal consumption expenditures price index —increased 3.1% in April from a year earlier, well above the central bank’s 2% inflation target. Prices are surging for a broad variety of products, from used cars and homes to commodities such as copper, steel, iron ore, oil and lumber.

The Fed will likely add more fuel to the fire. The central bank is on track by 2023 to expand its record balance sheet 14% to $9 trillion from $7.9 trillion today, further increasing the U.S. money supply, the central bank said last month, citing expectations of financial market participants.

Months of record monetary and fiscal stimulus aimed at offsetting COVID-19 pushed up household expectations for inflation in May to the highest level in a decade, according to a University of Michigan survey of consumers.

“The public is no fool,” according to Charles Calomiris, a Columbia Business School professor. “The surveys are showing a dramatic increase in the public’s expectations for inflation — we haven’t seen anything like this for 30 years.”

To many CFOs under 50, rapidly rising prices are a relic from their parents’ past, as quaint and unfamiliar as sideburns and bell bottoms. They may have only heard vague references about how double-digit inflation repeatedly savaged U.S. companies from 1974 until 1981.

“Current business managers haven’t lived through an inflationary period,” according to Barry Keating, a professor at Notre Dame’s Mendoza College of Business. “It’s not that they’ve forgotten the bad effects from rising prices, they didn’t learn about them in the first place.”

Even CFOs who doubt that an inflationary wildfire is approaching would do well, as part of scenario planning, to consider ways to limit the harm from rising prices, according to economists and financial executives. Such steps range from issuing debt, to building inventories, to hedging against a depreciating dollar.

This too shall pass

For their part, Fed policy makers predict that accelerating inflation is just a passing phase in the post-pandemic recovery. Price gains will eventually slow as pent-up demand fades and supply bottlenecks ease.

Instead of fighting inflation, policy makers favor letting it exceed their 2% target to make up for past shortfalls and reduce unemployment, now at 6.1%.

Some economists say that the central bank stoked high inflation during the past several months by holding down the benchmark interest rate at 0.25% and pumping up its balance sheet with $120 billion in monthly purchases of Treasury and mortgage bonds.

“The inflation rate over the next two or three years is already baked into the cake,” according to Steve Hanke, a professor of applied economics at Johns Hopkins University. He predicts 5% to 6% inflation next year and in 2023.

Rapidly rising prices torpedo strategic planning and upset relationships between a company and its suppliers, employees, customers, lenders and other stakeholders.

“It’s like taking out the mortar from between the bricks of the economy,” Keating said, warning that “inflation is going to get a lot worse.”

“CFOs lose the power to accurately predict what will happen in the near-term and long-term future,” he said, adding that “business relationships that have been constant for 40 or 50 years are going to change."

Faced with rising prices, many businesses hunker down and reduce investment. Borrowers gain at the expense of lenders. Economic growth may slow, the real value of savings falls and a depreciating dollar reduces the purchasing power of companies buying goods and services from abroad. 

In an effort to limit damage, companies may make bad decisions such as excessive overstocking or committing to long-term agreements on services.

“Businesses will lock in to long-term contracts that can turn out to be very foolish,” Keating said. “They will have a tendency to do things that they really know nothing about, and that can be really dangerous.”

Persistent high inflation can fuel a “wage-price spiral” as employees, confronting higher prices, demand higher pay. Companies, facing higher payroll and input costs, raise product prices.

A disruptive period of rising prices often ends in a bust. Eventually, a central bank will try to curb inflationary damage by raising interest rates, risking a recession and widespread unemployment.

Economists say that CFOs can blunt inflation’s edge by taking five steps:

1. Issue debt

With the benchmark 10-year Treasury note today yielding about 1.6%, CFOs should take advantage of low borrowing costs and sell debt, economists said.

“This is a good time to lengthen the maturity of your debt as much as possible and to think about issuing debt,” Calomiris said. After all, inflation over time will reduce real servicing costs.

“It doesn’t mean you go crazy and issue debt you can’t repay,” he said. “But it does mean you cross a little bit more in the direction of selling more debt of longer maturity.”

2. Buy goods and services at today’s prices

With inflation eroding purchasing power, CFOs should consider buying now the goods and services that they anticipate needing in the future.

“You want to be long inventories, long commodities, long goods and processes,” Hanke said. “That’s the smartest thing to do.”

A CFO needs to weigh the expected price increase against the cost of financing and carrying extra inventory. Such a strategy flouts a decades-long emphasis at many companies in slimming inventories in order to free up cash.

Still, “it’s a sure bet,” Hanke said. “If you anticipate the price is going to be up in the next three of four months by 10% or more, you better be long.”

3. Hedge against a falling dollar

CFOs at companies that heavily depend on imports may want to consider using a currency swap or similar financial tool to limit losses from depreciation of the dollar, the economists said.

A financial executive would need to take into account transaction costs and ensure the second currency is also not vulnerable to inflation.

“It’s not cheap,” Calomiris said, and “you’ll also have to know that those countries aren’t themselves subject to similar kinds of risks” as the U.S.

4. Cushion your company’s portfolio

CFOs should weigh moving a portion of their company investment portfolios into inflation buffers such as gold, Treasury inflation-protected securities (TIPS) and funds that track the prices of a basket of commodities, the economists said.

Financial executives should remember that no investment is a perfect inflation hedge, they said. Gold pays no yield and the prices of oil and other commodities can be highly volatile and vulnerable to geopolitical tensions. Diversification is essential.

First movers in hedging gain an advantage. “We can’t all be short the market,” Calormiris said. “There has to be somebody on the other side of the trade.”

Also, “if the economy is in the tank, then nobody is a winner” — some companies just limit their losses better than others, he said.

5. Learn from the pandemic

During a pandemic, bouts of inflation and other times of instability CFOs should exemplify “agile absorption,” or the ability to quickly seize opportunities while maintaining structural strengths such as a solid balance sheet, Hanke said, citing The Upside of Turbulence by Donald Sull of the MIT Sloan School of Management. 

“It’s a great way to think when you get into turbulence because most people just freeze up,” he said.

The sudden, unexpected onset of COVID-19 underscored to CFOs the value of agility — an essential trait when prices surge, the economists and financial executives said.

“The pandemic made companies much more agile,” Keating said.

Many CFOs used high volumes of near- and real-time data and data analytics to cut costs, tighten cash management and safeguard supplies. They discarded forecasting methods that primarily relied on spreadsheets and backward-looking historical data.

“Inflation brings massive change so you need to make your short-term forecasts very accurate,” Keating said. “You’ll need to track short-term indicators to keep your finger on what’s going to change.”

Hot Florida market

During the past century many Florida real estate developers discovered the value of agility as they grew familiar with a pattern of boom and bust. Still, the market of the past several months has seemed especially jarring to Amicon CEO Adam Mopsick.

Amicon, a Miami developer and project manager with more than $1 billion in assets under management, began 2020 anticipating a record year, Mopsick said.

The pandemic quickly blew up such expectations as clients en masse put projects on hold, he said. “There were a lot of scared people.”

Today, business is booming like never before, fueled by record-low borrowing costs, rebounding economic growth, pent-up demand for real estate, widespread vaccination and a flood of buyers from California, Illinois and other high-tax states, Mopsick said. Demand for luxury residential construction and other markets “is unlike anything we’ve ever seen.”

At the same time, prices are soaring for steel, copper, aluminum, glass, lumber and other materials, Mopsick said. Labor costs are also rising, with qualified subcontractors in short supply.

Amicon has had to mark up the cost of some projects by 20% during the past 12 months, and write in higher escalation contingencies to offset inflation, he said.

“We don’t want to budget on yesterday’s pricing,” he said. “We want to budget on the pricing that would be the worst case by the end of the project.”

Amicon is also ordering in advance materials that it will need during the next 12 months, including steel, piping, lighting materials, glass and glazing. “When we have an opportunity to lock in today’s pricing, we’re doing that.”

“I don’t know that we can maintain the level that we’re at right now,” Mopsick said, referring to the Miami real estate market. “A little bit of a pullback wouldn’t be the worst thing in the world.”

Overheated Tennessee

Speaking at a May 19 hearing of the House Financial Services Committee, Rep. David Kustoff, R-Tenn., delivered a similar message of moderation to Federal Reserve Vice Chairman Randal Quarles, a leading advocate of the idea that inflation will eventually subside.

Kustoff told Quarles that homebuilders and real estate agents in his west Tennessee district faced a “red hot” market beset by labor shortages and lumber prices rising at a 300% annual rate, making “it almost prohibitive to build homes.”

“How much longer can we expect that to continue and at what point does the Fed need to say, ‘Enough is enough’?” Kustoff said.

Quarles replied that on a few occasions during the past decade the Fed reduced stimulus to rein in inflation and prematurely throttled growth. “If we were to try now to stay ahead of the inflation curve, we could end up significantly constraining the recovery.”

Having determined that it repeatedly acted too early in quashing inflation, the central bank may now wait too long before trying to control prices, Keating said. “They may err on the side of inflation until it may be too late to easily stop.”