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Inflation outlook is positive for small & midsize businesses

Inflation outlook is positive for small & midsize businesses

Author
Fergus McCormick
Chief Economist and Senior Director of Economics at BILL
Author
Fergus McCormick
Chief Economist and Senior Director of Economics at BILL
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By Fergus McCormick, Chief Economist at BILL

Takeaway

Lower US inflation is good news for small and midsize businesses (SMBs) because it increases customers’ purchasing power, lowers SMBs’ labor and input costs, and makes it easier to run their business.

Introduction

BILL is a champion of SMBs, automating the future of finance so businesses can thrive. Hundreds of thousands of SMBs trust BILL to remove the complexities of financial operations, making paying bills, getting paid, and managing expenses simpler. This saves them time and allows them to focus on what inspired them to build their business in the first place.

The April 2024 NFIB Small Business Optimism Index showed that 25% of US SMBs consider inflation to be the single most important business problem in operating their business. This is in spite of the steady decline in inflation since it peaked in mid-2022. This year, the pace of downward momentum in inflation has moderated. This is mainly a result of housing rental prices, which have declined but have yet to show up in the main inflation indexes. A strong economy has also put upward pressure on prices; and tensions in the Middle East have contributed to higher world oil prices. Nevertheless, inflation has returned to a more stable level, and looks set to decline further this year. Price stability and lower inflation this year will increase customers’ purchasing power and make it easier for SMBs to run their business.

Consumer Price Index
Producer Price Inflation

Source: U.S. Bureau of Labor Statistics, BILL Economics

Causes of inflation

During the pandemic and in its wake, five factors appear to have been responsible for the return of inflation. First, as the pandemic hit, firms cut production and supply chain disruptions led to backlogs of work orders for goods and services. This pushed up domestic prices. Second, when the vaccines arrived, pent-up demand for goods pushed up prices. Third, the outbreak of the Russia-Ukraine war led to higher energy and food prices. Fourth, demand for housing soared as people began working from home amid limited supply of housing. Finally, labor market tightness contributed to higher costs.

Further price declines are likely

The Consumer Price Index (CPI) peaked in June 2022 at 8.9% compared to a year earlier. By March 2024 it had declined to 3.5%. The Producer Price Index, which measures wholesale prices and business-to-business costs, peaked at 11.7% in March 2022. In March 2024 it was 2.1%. (See charts.) 

This progress took a respite during the first quarter of 2024. However, I believe that inflation will trend downward later this year. The Federal Reserve’s 2% inflation target is a key aspect to this outlook. At 3.5%, the CPI remains above the Fed’s inflation target, but I expect it to decline to about 2.5% this year. (The core PCE inflation index, the index that the Fed uses to set interest rates, reached 2.8% in March - even closer to the Fed target.) This expectation is mainly based on 2 factors: first, inflation expectations remain well anchored at 2.4% (2.1% for PCE inflation). Second, and most important, actual single family rental inflation has declined and by some measures is back to its pre-pandemic level. It is only a matter of time before the rental components within the main inflation indexes catch up to actual rental inflation.

Housing prices are important because they account for 36% of the CPI and 24% of PCE inflation, and make up the biggest difference between actual inflation and the Fed’s inflation target. The delay in lower rental inflation in the main inflation indexes is mainly owing to an arcane method of calculating rental inflation: owners’ equivalent rent of primary residence. The Fed asks owners of single family homes what they would rent their properties for if they were to put them on the market. Historically, it has taken about a year for CPI rental inflation to catch up to actual rents. During this cycle we have yet to see this materialize. However, I expect this to begin to show up in the coming months.

If we exclude owners’ equivalent rent from the CPI, the difference comes to inflation growth that over the last few months has been at or below the Fed’s 2% inflation target. With the labor market at full employment, if inflation comes down consistently as I expect it will later this year, I would expect the Fed to begin lowering the Federal Funds rate in September.

Risks to inflation look manageable

There are two risks to the inflation outlook. First is the risk of inflationary supply shocks. If developments in the oil market and other global commodity markets push up energy and food prices, or if there is further disruption to supply chains, this could put upward pressure on inflation. Tensions in the Middle East have already contributed to a spike in oil prices. If oil prices become persistently high, this could lead the Fed to hold rates high amid weakening economic conditions.

Second is the risk of overheating. In 2023, economic growth averaged 2.5%, and in the first quarter of 2024 grew by 1.6% annualized. But given the strength of consumer spending, growth is closer to trend growth of 2%. An important driver of this growth has been the decline in inflation, which is increasing consumers’ purchasing power. Moreover, household savings are still high and the stock market has surged, creating a wealth effect for millions of Americans. Many homeowners were insulated from rate hikes, having locked in low rates on mortgages and other loans. If growth outperforms expectations, this could keep inflation high.

Bottom line

SMBs are right to be concerned about inflation. Many of them are not used to paying such high prices for inputs to the goods and services they sell. The good news is that this year I believe rents will decline, sending overall inflation lower. This will help to normalize demand and supply conditions and pave the way for lower interest rates, greater confidence, and a soft landing of the economy.

Author
Fergus McCormick
Chief Economist and Senior Director of Economics at BILL
Fergus McCormick, Chief Economist and Senior Director of Economics at BILL, brings extensive expertise in global economics. Before BILL, Fergus was Chief Economist at DBRS. He also held high profile roles at Morgan Stanley, the International Monetary Fund, and top credit ranking agencies.
Author
Fergus McCormick
Chief Economist and Senior Director of Economics at BILL
Fergus McCormick, Chief Economist and Senior Director of Economics at BILL, brings extensive expertise in global economics. Before BILL, Fergus was Chief Economist at DBRS. He also held high profile roles at Morgan Stanley, the International Monetary Fund, and top credit ranking agencies.
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