Currently, excessive inflation is giving Europe’s policymakers more problems than any other economic challenge. Inflationary uncertainty is also causing many businesses severe headaches as they attempt to plan for demand and set pricing strategy. It is not just that inflation has spiked so sharply over the past two years; the bigger issue is that traditional models for assessing the direction and impacts of inflation appear to have broken down.
Throughout the COVID-19 pandemic, governments and monetary policy authorities, including the European Central Bank (ECB) and the Bank of England, flooded the economy with cash in an attempt to prevent economic catastrophe. Many economists predicted that higher inflation would inevitably result from the combined effect of policies such as quantitative easing and direct financial support from governments to companies and individuals. Yet the projected high rates of inflation did not materialize.
Rather, the elevated levels of inflation we see today largely originate in supply-side shocks. First, the lingering effects of the pandemic led to supply chain and logistical disruption, causing shortages of products. The most prominent global example of this is microchips; manufacturers dependent on chips in industries from computing to automotive couldn’t keep up with demand. Then, Russia’s invasion of Ukraine in February 2022 triggered very high food- and energy-price inflation; in the euro area, inflation rose from 5.1% in January 2022 to 10.6% in October.
In other words, despite what conventional economic models tell us, Europe’s inflation problem is not structural. Rather, it reflects a supply-side shock: owing to external factors, the capacity of the economy to supply many goods has not been sufficient to meet demand.
In theory, then, inflation should begin to recede as that shock subsides. To some extent, this is what we are seeing. Prices in the automotive industry, for example, have fallen back as chip supplies have improved; food and energy prices have begun to moderate as the world has started to adjust to the impacts and implications of war in Ukraine.
The question is whether that decline will continue. Central banks are certainly determined to push prices down by continuing to implement interest-rate rises. Supply chain disruption will continue to ease, despite ongoing hostilities between Russia and Ukraine.
However, the hangover from the cheap money pumped into the economy during the pandemic may linger. Another potentially inflationary factor is the determination of trade unions to press for higher salaries for workers facing an increased cost of living in the last few years. Industrial action has the potential to further disrupt supply; successful union campaigns will support demand.
Moreover, we are having to rethink conventional wisdom about how consumers behave. Faced with higher prices, consumers should be cutting back on their purchases. In some areas of the economy, there are patterns to suggest this is happening; there are lots of instances of consumers shifting from branded goods to own-brand, budget alternatives. In the UK, for example, sales at discount supermarkets Aldi and Lidl are accelerating at the expense of previously dominant high-street stores such as Tesco and Sainsbury’s.
There are, however, a number of examples of counterintuitive consumer behavior. Demand for holidays, in particular, appears to be very strong. Perhaps understandably, even amid a widespread squeeze on consumer spending, people are determined to travel after the long period of pandemic-related restrictions. Early bookings across Southern Europe, for example, suggest this year may even break records.
It is difficult to predict how such themes will play out in the long term; not all behavioral changes will be permanent. For example, consumer research in the aftermath of the pandemic overwhelmingly indicated that the crisis had prompted people to rethink their buying habits to the benefit of society and the planet. Since then, however, there has been growing evidence that this change is being reversed by rising prices. One study found that 55% of consumers who purchase sustainably branded grocery products have already switched to non-eco-friendly brands in light of the increasing cost of living.
Some companies have been able to maintain revenue levels as higher prices have compensated for lower sales. Others are experiencing greater difficulties, finding themselves competing for a share of the consumer’s wallet not only with different brands but also different sectors altogether. Manufacturers of tomato ketchup, say, used to focus on bettering each other’s product, but now they also have to worry about whether potential customers will choose to spend money on a summer holiday and slash their grocery bills to compensate.
In such a marketplace, tried-and-tested strategies for demand planning lose value. The models that businesses have relied upon to set stock levels and to price their products are no longer fit for purpose.
Moreover, market volatility means that, even where a pricing approach works, it is not guaranteed to continue to do so indefinitely. In the UK, for example, a shortage of fresh fruit and vegetables earlier this year was partly the result of supermarkets’ determination to set prices for an entire season, as they had done in previous years. When it became apparent that poor weather had limited supplies of European crops, these prices were no longer realistic and the result was empty shelves.
Moreover, the drastic measures taken by European policymakers to control inflation by hiking interest rates will also take its toll on household finances as mortgage costs increase. The prospect of economic slowdown and even recession looms large; Germany has already slipped into negative growth.
Supply chain disruption will continue to ease, despite ongoing hostilities between Russia and Ukraine.
In the past, this would have automatically resulted in reduced consumer demand across the economy. Yet few organizations report any sign of this. Those that reduced capacity at the start of the year in anticipation of lower sales are now complaining about the lost opportunity as demand has remained steady.
There is only one way for organizations to cope with this uncertainty – they have to become far more flexible and agile. Those that used to plan demand and set pricing on a quarterly basis now need to do so monthly; those that planned on a monthly basis should be thinking about weekly updates. In order to react to the volatile environment more quickly, organizations will need to devote more resources to market analysis and intelligence, to planning, and to pricing strategy.
Some industries are doing this better than others; the concept of dynamic pricing is well-established in sectors such as travel and tourism, for example. What customers pay for a flight or hotel room will vary by the minute, as automated models reprice the product according to current levels of demand and capacity.
Elsewhere, this will be more challenging to achieve. Sectors where online sales do not provide such a high proportion of revenue will not be able to make such dynamic, automized and data-driven adjustments.
Moving to a new pricing model may be less than straightforward for many firms. Tesla, for example, has worked hard to shift to a more dynamic pricing model, changing the price of many of its lines far more frequently than is usual for the automotive industry. It is a data-based strategy that makes sense – but it has frustrated customers who buy a car one week only to see its price drop the next.
Tesla boss Elon Musk has described this approach as trying “to make the least dumb decision that we can.” In a world where the old economic models no longer work – and where consumer behaviors are less predictable than ever – perhaps, for the time being at least, this is what companies should aspire to.
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