How to Run a SaaS Business During Inflation

I’ll start with the basics, then work up to how one manages a business during inflationary (or potentially inflationary) times. I’ll sacrifice technical accuracy for the sake of greater conceptual understanding.

WHAT IS INFLATION?

First, inflation is the phenomenon of prices of goods and services increasing across an economy. It is problematic because it introduces pricing instability in the economy.

Let me give you an example. I happened to visit Turkey in 2001. In 2001 and for many years prior, Turkey had experienced inflation rates ranging from 50% to 100%.

This had several tangible effects.

First, if you go into any retail store in Istanbul, the items have no price tags. When I first saw this, I thought it was odd. How do you know how much it costs? You have to ask… for every item.

When I asked why, I was told it was because COGS (cost of goods sold) would change each week. COGS would increase. This would compress margins, making every product that was priced based on last week’s rate unprofitable this week. Merchants got tired of revising all the price tags on the shelf every few days, so they just removed all price tags.

The second thing I noticed was how many partially built homes there were in the Turkish countryside with no construction crews working on them. These were homes that had framing and lumber but no walls and no roof.

Initially, I thought this was simply a work in progress. However, I noticed every home I saw was like this. I was confused. So, I asked why.

It turns out that mortgage rates in Turkey were about 250%. That means that on a Turkish mortgage equivalent of 100,000 USD, your principal balance after your first year was 350,000 USD. In effect, nobody borrowed any money. Because there was no financing, there was no residential construction.

As you can see, inflation does some really odd things in an economy. It’s a massive distortion that creates a lot of uncertainty.

Now, let’s talk about what causes inflation, what sustains inflation, what some possible inflation scenarios are in the U.S., and what contingency plans you want to have at the ready, depending on what happens.

WHAT CAUSES INFLATION?

Inflation is caused by two things:

1. Pre-existing inflation (Let’s call this momentum inflation.)
2. Triggers that create inflation initially (Let’s call this root-cause inflation.)

Inflation Cause #1: Pre-Existing Inflation (a.k.a. Momentum Inflation)

So, the #1 cause of inflation today is inflation yesterday. Yes, let me repeat that because it is the thing to appreciate about inflation that most people don’t get.

Inflation exists (and persists) because it already exists.

If that sounds a bit circular, it’s because it is. Inflation is a self-reinforcing cycle.

Let me explain how this plays out practically.

Let’s say there’s an increase in COGS. You think, “I’m a SaaS company. My margins are high. I’m not buying physical goods. It doesn’t apply to me.” You’re wrong.

Here’s why.

Let’s say that a manufacturer has increased costs for raw materials, energy, and transportation. What do they do? Initially, they might absorb the cost, but eventually, they’ll have to raise prices (or go bankrupt). So, they raise prices.

Now every manufacturer is under the same pressure, so they do it too.

Then, when your employees go to buy groceries and household goods, prices are now higher. Hmm… Over time, they find they can’t buy as much as they used to. There’s one solution to this. They legitimately need a raise to make ends meet.

So, they demand a raise from you. I’m not saying an employee demands a raise from you… they all demand raises from you at the same time.

What are you going to do?

You can’t lose all of your staff.

At some point, you have to increase your compensation costs. If you do, your margins get compressed. If the inflation is severe enough — and depending on how much cash reserves you have and are willing to use — at some point, you’ll have to raise prices too.

Now all of your customers have higher prices from their raw goods suppliers, from their employees, and from you too. They recalculate their financial forecast, and they realize that the math doesn’t work. They need to get ahead of this, otherwise, they’ll get squeezed.

So rather than react to input cost escalation after the fact, they decide to be proactive by raising prices now to get ahead of the curve.

Now, the things your employees buy at the store and Amazon are getting a lot more expensive quickly. This is crazy. Rather than get squeezed after the fact, they decide they need to be proactive too. They decide to ask you for another raise, and this time, a bigger one.

Again, it’s not just one employee who does this, it’s all of them… at the same time. Of course, you’re not dumb. You see the writing on the wall… so you get proactive too.

This is momentum inflation at its worst. Once inflation gets going, it’s very hard to stop. (More on how government policy can stop inflation in a moment.)

Inflation Cause #2: Triggers that Cause Initial Inflation (a.k.a. Root-Cause Inflation)

So now, let’s talk about the other triggers of inflation — the two “root-cause” triggers of initial inflation.

Root-cause inflation is a byproduct of using currency (U.S. dollars, euro, yen) for trade.

Prior to the invention of currency, people conducted commerce. They traded goods.

I will trade you two cows for a two-seat license to your SaaS app. (Well, maybe not exactly like that, but you get the idea. )

In a barter economy, there is no such thing as inflation. There is only supply and demand.

If there is a shortage of cows, the price for cows goes up. Most people get the idea of supply and demand. It makes intuitive sense.

Things are different when currency is involved.

Currency’s original purpose was convenience.

It’s hard to carry a cow around if you want to buy some lettuce at the market. It’s hard to sell only part of a cow. It’s hard to make change when someone gives you a cow for some lettuce, and you owe them 98% of a cow.

Originally, the amount of currency in a system was fixed.

The number of dollars, euros, or yen in an economy did not originally change.

In such a system, prices only reflected supply versus demand. A cow shortage still makes the price of a cow go up. That price increase is now communicated in dollars, euros, or yen.

Where things get weird is when the amount of currency in an economy isn’t fixed. When the supply of currency increases, prices are adjusted not because of changes in supply and demand but because of changes in the currency in circulation.

In the barter economy, let’s say that one cow is traded for one storage shed.

1 cow = 1 storage shed

In an economy with a fixed currency supply, a cow might be priced at $1,000. A storage shed might also be worth $1,000.

The relative value of a cow and a storage shed are still the same.

A $1,000 cow = A $1,000 storage shed

Now, this is where things get interesting.

Let’s say that the government decides to mint more coins or print more paper currency. There is now twice as much currency in the local economy as there was before. What is a cow worth? What’s a storage shed worth?

The cow is now worth $2,000. The shed is now priced at $2,000.

However… and this is important… the relative price between the cow and storage shed is still the same.

A $2,000 cow = a $2,000 storage shed

Even though the prices doubled, the actual relative value is the same.

This is, in fact, one of the two root causes of inflation: an increase in currency or money supply.

As a result, one of the two root causes of inflation is the increase in the money supply. (This is also known as monetary stimulus.)

In governments around the world, there’s one institution that has the power to increase the money supply. They are the central banks. In the United States, the central bank is known as the Federal Reserve.

When the Federal Reserve wishes to stimulate the economy, they have a mechanism by which they increase the money supply. If you hear terms like “Federal Reserve open market operations,” “quantitative easing,” or “monetary policy,” these refer to the mechanism by which the money supply is increased.

To oversimplify a bit, the Federal Reserve tells all the banks in the U.S. that they are willing to lend them huge amounts of money at very low (and even 0%) interest rates. The banks take the Fed up on this offer. The banks now have a ton of cash in their reserves at low costs. They then lend the money out to you and me as mortgages, car loans, credit cards, and the like.

(Note: The Federal Reserve is the only entity in the United States that has a “checking account” with an unlimited balance. It can transfer unlimited funds to commercial banks.)

Since the bank borrows from the Fed at really low interest rates, the banks, in turn, can lend to you and me at low interest rates too and still make money.

Traditionally, the idea was that in a recession, the Federal Reserve would stimulate the economy in this way to compensate for a shortfall in demand due to a recession. As the economy recovers, the Federal Reserve reverses what it did during the recession. They pull back these efforts.

The idea was that this would allow for smoother economic cycles. The recessions would not be as harsh. The booms would be slightly less vigorous. However, the Fed’s tendency has been to provide such stimulus in all types of economic environments.

This kind of money supply or monetary stimulus in all environments contributes to inflationary risk.

If you think about it, it makes sense. If you can now buy a car with $0 down and a 1% interest rate, why not buy a new car? If you can buy a house at 2.5% interest, why not buy a new one? Etc.

The second root cause of inflation is increased spending by the federal government. (This is also known as fiscal stimulus.)

In a recession, it can make sense for the federal government to step up its spending to make up for spending shortfalls by businesses and consumers. This is known as fiscal policy.

The theory is that the government spends more in a recession, then when consumers and businesses are spending like crazy, the government pulls back spending. This, too, makes the bottom of recessions less painful and the peak of boom times slightly less vigorous.

However, in the United States, our federal government tends to spend a lot in all times — good times and bad.

In a regular business, without venture capital and debt lines, you only survive by spending less than what you make in revenue. When sales exceed costs, you’re profitable. When costs are greater than revenues, we businesspeople call that being unprofitable.

The U.S. government is highly unprofitable. It spends way more than it receives in tax revenue. Going back decades, every president has done this. Legislators from both parties do this. They can’t help it. It is just too tempting to spend a lot of money to make your voters happy so they re-elect you.

In normal years, the U.S. government is unprofitable. In crisis years, it’s even more unprofitable. This occurs when the government borrows even more so it can spend money it does not have.

The obvious benefit is the increased demand that allows businesses to have more money to pay employees. The less-obvious downside is that this contributes to inflation risk and inflation itself. Here’s why.

When demand goes up, but supply is fixed, prices go up. When the federal government spends trillions more in a particular year than it normally does, that’s extra demand. It puts upward pressure on prices. Suddenly, there are more people with more money who want to buy more “cows,” and there aren’t enough cows to go around. Prices go up as a result.

So, the combination of monetary policy and fiscal policy, increasing the money supply and increasing government spending, is a double whammy that causes upward pressure on prices.

HOW TO MEASURE INFLATION

There are two ways to measure inflation.

1. Inflation of Consumables
2. Inflation of Assets

The first is to track the prices of things people consume. My unofficial term for this is “inflation of consumables” (e.g., bread, eggs, milk, electricity, gasoline, etc.).

This first type of consumables inflation is what most people think of when it comes to inflation. In the United States, it is measured by something called the Consumer Price Index (CPI). Most countries have some version of this index. The CPI is a formula that takes the current prices of commonly consumed goods (e.g., groceries, electricity, gasoline) and creates a score. This score is used to gauge the change in prices from one month, year, or decade to the next.

When I was a kid, ice cream was $0.25 to $0.50 for a scoop. Today, it might cost $4.00 a scoop. The difference between the two reflects the inflation of the ingredients to make ice cream (cream, sugar, etc.).

The second type of inflation is asset inflation. Most people do not think of increases in asset prices as inflation. Assets include stocks, bonds, single-family homes, and cars.

When consumers have a lot of money from either near-interest-free debt (think: home mortgage, car loan, credit cards) or fiscal stimulus (abnormally high government spending in a variety of forms that eventually ends up in consumers’ hands), they deploy it. There are really two primary things consumers can do with extra cash. They buy things they consume (which is tracked by consumption inflation), or they buy assets that are more durable (homes, cars, stocks).

As a result, things like the S&P 500 stock market index are, in part, a measure of inflation. The Case-Shiller Home Prices Index that measures the average price of a home in the United States is also, in part, a measure of inflation. If you track the prices of new and used cars, that is a measure too. When you look at the valuations of every asset class, and all of them are at record highs, that can be a sign of asset inflation.

Now that you have a baseline understanding of how inflation works, let’s focus on how this impacts your SaaS business, how you should prepare for inflation, and how you should respond after it hits.

HOW INFLATION IMPACTS YOUR BUSINESS

Inflation impacts four parts of your business:

1. Expenses
2. Sales
3. Debt
4. Equity

1. Expenses

As you might intuitively guess, inflation increases your expenses. Everything from physical goods to labor costs tend to go up. Increased expenses put downward pressure on margins and on EBITDA (earnings before interest, taxes, depreciation, and amortization) or operating profit… especially if the prices you charge do not go up at the same or greater percentage.

(Remember, even if you’re not buying physical goods, your suppliers and employees likely do. To cover the increases in their physical good costs, they’ll demand higher wages or prices.) While this is not an overnight process, it can be a very real problem with potentially devastating consequences.

To understand why, we have to look at sales.

2. Sales

In normal years, it’s advantageous to have your clients sign long-term contracts. This reduces churn, increases net revenue retention, and generally increases enterprise value as a result. However, in inflationary environments, fixed-revenue contracts can be dangerous as they collide with rising costs (due to inflation).

Customers often buy into long-term contracts to be guaranteed fixed prices and thus predictability for their budgets. When your prices stay flat because of fixed contracts but your suppliers’ prices rise significantly, what happens is that your profit margins shrink.

This is how a business can go under in an inflationary environment.

There are two solutions to this problem.

First, you never want to have truly fixed-price contracts. At a minimum, you want to have some kind of automated, inflation-based price increase included in your contract. Many SaaS contracts have an automatic 3% price increase included. It’s often around 3% for a few reasons. First, historically the Consumer Price Index runs around 3% per year. Second, customers and their legal counsel know this, so when they see a 3% price increase, they perceive that as normal and just the price of doing business.

However, if inflation were to rise to 7%, 10%, 15%, or more, the difference between the inflation rate and your automated price increases gets taken out of your profit margins.

If inflation looks temporary and modest, a numerically defined annual price increase (like 3%) is probably fine. You take the hit for a few quarters or a year or two, and hopefully, things get back to normal.

However, the longer inflation persists and the greater the degree of inflation, the more a fixed-price-increase clause (especially one around 3%) becomes a problem. Let’s look at a more extreme example.

To keep the math simple, let’s say your annual contract value (ACV) is $100 and a three-year term with a 3% automatic price escalator.

This is your ARR for the duration of the contract:

Year 1: $100 ARR
Year 2: $103 ARR
Year 3: $106 ARR

Let’s say you’re in growth mode and run the entire business at a 0% EBITDA margin. Basically, you break even.

In a normal inflationary environment, this is what your per account P&L looks like when you expect your own suppliers to raise prices by 3%.

Year 1: $100 ARR – $100 Costs = $0 Profit (0% Profit)
Year 2: $103 ARR – $103 Costs = $0 Profit (0% Profit)
Year 3: $106 ARR – $106 Costs = $0 Profit (0% Profit)

Now let’s say that inflation runs at 15%. Let’s recalculate the three-year account-level P&L:

Year 1: $100 ARR – $115 Costs = -$15 Profit (-15% Profit)
Year 2: $103 ARR – $132 Costs = -$29 Profit (-28% Profit)
Year 3: $106 ARR – $152 Costs = -$46 Profit (-43% Profit)

• Like interest rates, inflation compounds… and when it does, it is brutal.

Three years at 15% inflation is devastating to profits in this scenario.

There are a few solutions:

1. Steer away from long-term sales contracts in inflationary conditions (for new customer acquisition and customer renewals).
2. Rewrite contracts to have a higher annual price increase clause (for new customer acquisition and customer renewals).
3. Rewrite contracts to have annual price increases tied to some measure of inflation like the CPI (Consumer Price Index), Wall Street Journal Prime Rate, or LIBOR (London Interbank Offered Rate) (for new customer acquisition and customer renewals).

This doesn’t solve the problem of existing customers on long-term fixed-price or fixed-price-increase contracts, but at least you don’t make the problem worse going forward.

3. Debt

Scenario A: Fixed-Rate Debt

If you have fixed-rate debt, inflation benefits you… especially if you’re able to raise prices.

Let’s say that you have a monthly debt payment of $100. In a typical year, you receive an average MRR (monthly recurring revenue) of $100.

Monthly debt service P&L:

MRR: $100
Debt Costs: -$100
———————————
Profit: $0

Let’s assume that you don’t have any long-term sales contracts. As inflation rises, you raise prices to match. Let’s further assume that inflation is 15% per year.

Here’s what a slightly over-simplified P&L looks like:

Year 1:

MRR: $115
Debt Costs: -$100
———————————
Profit: $15

Year 2:

MRR: $132 ($100 x 115% x 115%)
Debt Costs: -$100
———————————
Profit: $32

Year 3:

MRR: $152 ($100 x 115% x 115% x 115%)
Debt Costs: -$100
———————————
Profit: $52

In this scenario, you’re getting artificial revenue growth from inflation, but your debt payments are fixed. This is an optimal situation.

Scenario B: Variable-Rate Debt

While it is possible to get bank loans with fixed interest rates, it’s far less common to get that with venture debt financing. Most venture debt financing has an interest rate that “floats” with the prevailing interest rates of the day. You’ll see interest rates expressed on venture debt term sheets as follows:

Interest Rate = Wall Street Journal Prime Rate + X%

The interest rate is expressed as “markup” (known as interest rate spread) over and above the current day’s prevailing interest rate. This type of structure protects lenders from inflation risk… and passes that risk back to you.

Variable-rate debt can be absolutely brutal in inflationary times. Here’s why. When inflation increases, so do interest rates.

Here’s an example.

Let’s say you have venture debt financing as follows:

Interest Rate = Wall Street Journal Prime Rate + 10%

In a low-inflation-rate, low-interest environment, the Wall Street Journal Prime Rate is close to the inflation rate.

For argument’s sake, let’s say that a low-interest-rate, low-inflation-rate environment is one where inflation is 3% and the Wall Street Journal Prime Rate is also 3%.

In this scenario, the interest rate on your venture debt is 13%.

Venture Debt Interest Rate = 3% Prime Rate + 10% Markup on Prime Rate = 13%

Now let’s say that inflation skyrockets to 15%, and as a result, so does the Wall Street Journal Prime Rate.

New Interest Rate = 15% (Wall Street Journal Prime Rate) + 10% = 25% (Brutal!)

The effective interest rate nearly doubles, which ends up increasing monthly debt service costs by about 24% (assuming a four-year, fully amortizing term).

An unexpected 24% increase in monthly debt service in an environment where customers have a lot of macroeconomic uncertainty adds even more pressure to your business.

If you have a lot of variable-rate debt financing, unexpected rising interest rates (from rising inflation rates) can be devastating.

Financing Rules of Thumb during High Inflation:

• Fixed-Rate Financing = Good
• Variable-Rate Financing = Bad

4. Equity

How inflation impacts equity on the balance sheet is unclear. For some businesses that take advantage of opportunities that only emerge during inflationary times, shareholders can benefit. For other companies, inflation can severely damage a business’s finances and thus its value to equity holders.

To massively oversimplify, businesses that can raise prices (and whose customers will tolerate the price increase) tend to either do well or, at least, neutral during inflationary times. Businesses that are not able to do so tend to suffer.

Now let’s take a look at the opportunities that emerge or are unusually beneficial during inflationary times.

OPPORTUNITIES IN INFLATIONARY ENVIRONMENTS

In addition to the opportunities mentioned above (borrowing money with fixed and low interest rates), here are a few more opportunities to be aware of that become appealing or more appealing during inflationary times.

A. Locking in Major Expenses at Low, Fixed Prices (typically before high inflation kicks in)

If you see high inflation coming (correctly and before others do), there can be an opportunity to negotiate long-term fixed-rate expense contracts. One example is real estate leases. As inflation increases, the interest rates that landlords must pay in their debt services go up. This prompts them to raise rental rates to cover the higher debt services. If you have a long-term lease with a fixed annual lease amount, in an inflationary environment, you benefit (and your landlord suffers).

If the price of electricity goes up significantly, and with it, the cost of cloud computing services that you rely on, then locking in a fixed-price contract early can be beneficial.

However, there is one major caveat: inflation tends to destabilize customers. Inflation tends to create unpredictability for businesses and their customers. When things are uncertain, it’s harder to plan. If demand for your offerings does not change and inflation is high, then locking in long-term contracts is beneficial. However, if inflation destabilizes and reduces customer demand for your offerings, then the last thing you want to do is get locked into a fixed long-term expense for a resource (like office spaces) that you don’t end up using. That’s not good either.

B. Selling to Customers in Foreign Countries without Inflation and Pricing in Local Currency

Another opportunity in inflationary times is to sell to international customers located in countries with low inflation, price your offerings in the local currency, and retain your profits in the same currency.

Let me explain why.

Americans under the age of 65 generally have not operated a business in an inflationary environment. All of their intuitive economic life experience is premised on low inflation.

If you talk to anyone who lived in Turkey in 1994, Brazil in 1990, or Hungary in 1945 (where prices doubled — get this — every 15 hours, and the inflation rate was so high it was only expressed in scientific notation), they have completely different life experiences.

What these people appreciate that Americans don’t is that, in times of inflation, one’s currency gets devalued.

Let me explain with an example.

Let’s go back to our example of buying a cow.

In a non-inflationary economy, 1 cow = $1,000

Or stated in different terms, a single dollar can buy 1/1,000th of a cow.

Let’s say that there’s 100% inflation.

1 cow = $2,000

That makes sense. Prices doubled.

But look at what happens when we look at the purchasing power of $1.

A year ago, $1 could buy 1/1,000th of a cow.

This year, $1 can only buy 1/2,000th of a cow.

The dollar is worth less with each passing day.

With hyperinflation, every person in that country knows that you don’t want to hold your own currency. You don’t want it in your bank account. You don’t want it in your wallet. You don’t want it stuffed under your mattress.

What every person in Turkey in 1994, Brazil in 1990, or Hungary in 1945 knew was that you desperately wanted some other country’s (more stable) currency instead.

Here’s an example.

Let’s say that we are comparing the price of a loaf of bread in the United States to one in Europe.

Let’s also say that in normal, low-inflation times, a loaf of bread in the United States = a loaf of bread in Europe.

So, to oversimplify a bit:

1 USD = 1 Loaf of Bread in U.S. = 1 Loaf of Bread in Europe = 1 Euro

One USD buys one loaf of bread in either country. One euro does the same. Everything is equal to everything else.

Now let’s say that we have 100% inflation in the United States, whereas Europe has no inflation. So, what happens in this scenario?

As you might intuitively guess, the price of bread (in U.S. dollars) goes up.

2 USD = 1 Loaf of Bread in U.S. = 1 Loaf of Bread in Europe = 1 Euro

It takes two USD to buy a loaf of bread in either country. However, a loaf of bread is still worth a loaf of bread. And as such, one euro still buys a loaf of bread in either country.

But with inflation, 1 USD only buys half of a loaf of bread.

So, how does the math work out this way?

Let’s think about it.

Back in the barter economy, a loaf of bread is worth a loaf of bread. Currency was simply a more portable way to transact compared to stuffing your pockets full of multiple loaves of bread.

When one country has inflation, but another does not, the actual bread does not change. The usefulness of the loaf of bread does not change. It still makes the same number of sandwiches before and after inflation. What does change is the perception of pricing.

Because of the intrinsic value of a loaf of bread, currency exchange rates shift to compensate for inflation.

In other words, in non-inflationary times, 1 USD = 1 euro = 1 loaf of bread.

With 100% inflation, like the example above, 2 USD = 1 euro = 1 loaf of bread.

If there’s a second year of 100% inflation, then 4 USD = 1 euro = 1 loaf of bread.

If there’s a third year of 100% inflation, then 8 USD = 1 euro = 1 loaf of bread.

In year one, 1 USD = 1/2 of a loaf of bread.

In year two, 1 USD = 1/4 of a loaf of bread.

In year three, 1 USD = 1/8 of a loaf of bread.

Each year, the U.S. dollar buys less and less bread.

In contrast, in Europe (in this hypothetical scenario), 1 euro = 1 loaf of bread across all three years.

So, this means that businesses in inflationary economies that export to other countries with low inflation do well. You ideally want to price your offerings in the local currency (euros, in this example). Even better would be to have your cash reserves, savings, and checking accounts held in the same currency (euros, in this example).

[Sidebar: This has numerous cross-functional implications. Is your SaaS application multilingual, and does it offer localization features? Do you have multicurrency banking faculties set up? If you sell to the SMB market and take credit cards, is your credit card processing system able to take payments in foreign currencies without automatically exchanging funds into U.S. dollars? Is your data storage architecture compliant with other countries’ privacy laws? Do you have the capacity to generate leads outside the United States? Do you have technical support coverage during business hours in the new countries you might do business in? What sales capabilities do you have to sell into new geographic markets?

Would I execute these decisions right now? No. Would I spend a few hours mapping out a preliminary contingency plan? Yes. Would I research the plan more thoroughly if and when inflation intensifies? I would. Would I start building multilingual, multicurrency optionality into my tech and billing stack? I might look into the cost and feasibility of it. Would I keep a very sharp eye on various inflation indicators like the CPI and S&P 500? I absolutely would.]

These are the dynamics at play for businesses during high inflation. It’s a bit of a rollercoaster.

But wait… there’s more… (the rollercoaster ain’t over yet).

Let’s look at how inflation ends.

HOW GOVERNMENT POLICIES CAN END INFLATION

(And Why the “Cure” Can Be Worse than the “Disease” for Business Owners)

As you can see, inflation, at best, creates uncertainty, and at worst, creates chaos. It’s destabilizing. If you don’t know what your sales and expenses will be (as they get distorted by inflation), then how do you plan?

Just as there were two underlying root causes to creating inflation — increased money supply and increased government spending — there are also two ways to stop it: a reduction in the money supply and a reduction in government spending.

However, it is not so simple.

As I mentioned previously, the #1 cause of inflation today is inflation yesterday. I called this momentum inflation. It turns out that momentum inflation is very tough to stop. Once everyone realizes there’s inflation, then every player in an economy tries to get ahead of the curve. Companies try to raise prices for customers before the company’s suppliers do the same to them. Employees demand higher wages as they anticipate a loaf of bread that used to cost $5 will now cost $6 or $7.

Even if the government pulls back from one-time spending, that’s often not enough to stop the momentum and expectations around anticipated inflation.

It turns out that the key lever to stopping inflation is to decrease the money supply. The primary way this is done is by the central bank (in the United States, that’s the Federal Reserve) raising interest rates.

Think about it.

What happens when interest rates go up?

If interest rates on mortgages go up a lot, that’s going to create massive mortgage payments. You’re not going to be so quick to buy a house and can no longer afford to offer over the asking price to buy it. Housing prices then come down.

If car loans are no longer 1% interest and are now, say, 5%, 10%, or 15% interest, consumers can’t afford car loan payments that are 50% more than they used to be. So, they only buy cars that are priced lower. Car prices come down as a result.

When your venture debt financing payments skyrocket, suddenly, you’re massively cash-flow negative. You can’t afford to make payroll unless you do layoffs. You do layoffs. Your competitors do layoffs too. Your suppliers do layoffs. Your customers do layoffs. With so many laid-off workers wanting work and noticing how much competition there is for jobs, they’re willing to work for less money than they did before. Wages come down.

If credit card interest rates double, those credit card payments balloon quickly. Consumers aren’t as quick to spend, so prices on consumables go down because there is less demand.

If this pattern sounds familiar, it’s because it is… It’s what happens in a recession.

Yes, the surefire cure for inflation is to deliberately create a recession!

(I did say the rollercoaster ain’t over yet, didn’t I?)

There’s a reason they call these things “business cycles” or “economic cycles.”

In practice, creating a recession is not the hope and desired outcome of a central bank like the Federal Reserve. What the Fed does do is steadily raise interest rates in order to suppress demand. The tricky thing is that it’s hard to get the rate increases exactly right. If you raise interest rates too modestly and too late, inflation momentum takes over. If the Fed raises interest rates too much and too fast, they create a recession.

So, the sweet spot for managing interest rate increases (known as reducing the money supply) is to raise interest rates just enough to cool off crazy levels of spending on consumables and purchasing of assets, but not so much as to create a recession.

It is notoriously difficult to get exactly right.

What is true is that the greater the inflation and the stronger the inflation momentum, the more it makes sense to aggressively raise interest rates (by raising them a lot and doing it fast) and risk creating a recession. Recessions are bad, but runaway inflation is horrible.

Once inflation momentum gets going, there are no good options — only bad outcomes and worse outcomes.

It’s a bitter pill to swallow to intentionally create a bad outcome solely to avoid a worse one.

Yes, amputation saves lives, but damn… I kind of like my limbs, you know what I mean?

So… what does this mean for you?

Two things:

1. You have to prepare contingency plans in case there’s persistently high inflation.
2. You also have to prepare contingency plans in case there’s a recession.

(I did say the cure can be just as bad as the inflation disease, didn’t I?)

The key takeaway here is contingency plans. You need to be prepared to adapt to a very wide range of possible scenarios… and be able to adapt quickly.

If you’ve read this far (which if you have, I thank you, as I wonder whether anyone is actually interested in this stuff or if I’m typing at 1:30 a.m. for no good reason), you’ve likely reached the same conclusion that I’ve reached.

Inflation sucks.

It really does.

It’s far easier to prevent inflation than it is to try to fix it once momentum kicks in. That said, you as a CEO can only control what you can control.

I hope this guide provides you with a primer on how inflation works, what signs to look for, what threats to avoid, and what opportunities to consider.

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