Inflation is a topic that affects everyone, from businesses to consumers, from governments to investors. It is a measure of how the prices of goods and services change over time, and it can have significant implications for the economy and society.
Currently, we’re observing a grey zone in the inflationary wave, following the initial shocks experienced over the past few years. In this blog, I’ll explore how inflation is evolving and how businesses can navigate this challenging landscape. To achieve this, we have developed a methodology around leading indicators, which can help companies better anticipate inflation trends and adjust their business strategies accordingly.
The first point I would like to make is that businesses need to understand turning points in their operations beyond classical analytics. Traditional methods can forecast trends but often fail to capture important inflection points.
Our leading indicator methodology addresses this gap by using predictive external information that can forecast trends and turning points with higher accuracy. Some of the leading indicators that can provide early signals of inflation trends are commodity prices, bond yields, consumer confidence, and business surveys.
To improve your company’s forecasting abilities, a correct view on market evolution is essential. This is especially the case when we look back at the series of unprecedented economic disasters in recent years. With traditional forecasting methods, which take information from the past and project it into the future, it is next to impossible to predict these kinds of events. But if you identify certain economic elements, or leading indicators, that will influence forecasting in the future, then you can predict and prepare for a lot more unexpected market fluctuations (dotted line in graph below).
With the technique of leading indicator forecasting (LIFe) we can determine which external indicators (regional or global) were making the same turning points as their sales data, but already a couple of months in advance. We then use those indicators to pinpoint when a sales turning point is coming up, after which we can train our model and apply our traditional forecasting techniques to extrapolate short- or long-term trends, seasonality, etc.
This approach is based on scientific methods and involves:
Now that I have given you some background on our leading indicator methodology and it’s importance in predicting inflation trends, let’s take a deeper look at the history of inflation, its drivers, its impact on businesses and the outlook on future inflation trends.
Inflation is the rate at which the value of a currency falls, leading to a general increase in the price level of goods and services. It is typically measured using the Consumer Price Index (CPI), which tracks the prices of a basket of goods and services. The goal of Western nations, for instance, is to have a CPI around 2% (without food & energy prices).
In the 1980s, inflation was very high, around 12.5%, after which it began to normalize between 2 and 5%. After the global financial crisis in 2008 and up to the COVID-19 pandemic in 2020, inflation stabilized around the central bank target of 2%. However, in June 2022, inflation peaked at 9% and is currently between 3% and 4%, significantly above the target.
Initially, both demand and supply factors drove inflation. During COVID however, supply issues dominated the global market, but as lockdowns eased, both demand and supply pressures surged. Today, supply-driven inflation remains a significant factor, but this is not the only factor in play.
Central banks aim to maintain inflation around 2% while maximizing employment. They use tools like interest rates and asset purchases to manage inflation. However, government fiscal policies, such as energy price supports and economic stimulus measures, can counteract these efforts, leading to higher inflation. Recent examples of this are the climate support acts, the Inflation Reduction Act in the US and economic support packages, such as the Chips Act in the EU and the US.
The transition to green energy requires significant investment, leading to short-term higher costs for energy and raw materials. This transition, while necessary, contributes to inflationary pressures. And I don’t have to remind you that energy prices were a major driver of the previous inflation wave.
Increased military spending, such as the US defense bill for aid to Ukraine, Israel and the Indo-Pacific, creates additional demand and strain on resources, contributing to inflation.
Finally, we’re still experiencing supply shortages, particularly in electrical components and chips, that continue to exert upward pressure on prices (cf. graph above).
High interest rates make borrowing more expensive, which can affect business strategies and profitability (cf. ECB deposit rates below). This can create a focus shift from investing in future growth to making profit, an effect which we have seen often the past few years at our customers.
Rising costs for raw materials, energy, transportation, food and wages (due to higher employee demands to pay for food and energy) can squeeze profit margins. Even though these costs are not as high as in 2022, they are still above pre-COVID levels. Monitoring these costs is crucial for maintaining profitability.
Consumers are becoming more conscious of their spending, with personal saving rates declining. This means the amount of disposable income consumers can spend is a lot lower than right after the COVID-period. This affects demand for high-ticket items and can impact sales.
Understanding the bargaining power of suppliers and clients here is crucial. Strong suppliers and clients can force price adjustments, affecting margins and overall profitability. Price increases that are blocked or pushed can lead to margin squeeze for instance.
First of all, we do not expect a significant second wave of inflation like the one seen in the past two years.
However, inflation is likely to remain above the 2% target due to ongoing pressures, but they will not be as large as the past few years.
Now that you have a better insight into inflation, along with its drivers and impact, I’ll show you how you can predict inflation trends and take strategic actions with your business accordingly.
Mapping your supply chain can provide visibility into where strong players (who can block price increases) are and how demand evolves in each level of the value chain. This allows for better strategic planning and risk management. Below, you can find the example of a chemical player’s supply chain (supplying car manufacturers) using several proxy indicators (i.e. closely linked variables that are used to estimate the behavior of an immeasurable variable).
These dashboards capture the behavior of downstream demand, inventory levels, and price trends, which can provide early warnings of market shifts, allowing for proactive adjustments. Below you can see the dashboard of all leading indicators for car demand (vehicle sales, industrial production, etc.) running in sync before COVID and out of sync after COVID (cf. demand-supply imbalance due to semi-conductor shortages).
Next to demand or downstream behaviors, we can also observe these trends in inventory modelling. The pandemic affected inventory levels differently across the value chain. Domestic auto inventories (green line) dropped sharply due to high demand and low production, causing a depletion of available cars. Conversely, inventories for motor vehicles and parts (blue line) surged as OEMs (original equipment manufacturers) continued to order parts despite incomplete vehicle assemblies, leading to an accumulation of unfinished goods.
Price monitoring can also provide critical insights into market trends. For example, a scarcity of new vehicles often drives up the prices of used vehicles. By linking vehicle sales with price trends, companies can anticipate market movements. When new vehicle availability is low, used vehicle prices rise, and once the availability normalizes, prices stabilize.
Up until now, I’ve dealt with qualitative insights, but leading indicators can also provide quantitative insights that allow companies to predict future trends. For example, once sales indicators start to normalize, businesses can expect their demand to stabilize in the following months. Quantitatively, these insights can be used in forecast models to combine various indicators, both intuitive (like vehicle sales) and less direct (like consumer confidence), to predict future demands more accurately.
As I’ve discussed in this blog, traditional statistical methods often extrapolate past trends into the future, which might not always be accurate. By identifying leading indicators, businesses can better anticipate changes in demand. For instance, consumer confidence can be a leading indicator for vehicle sales, as an increase in confidence typically leads to higher vehicle purchases after a few months.
As inflation poses significant risks to businesses, affecting both profitability and demand, it is crucial to learn how to predict inflation trends. While we do not foresee a major second wave of inflation, it is likely to remain above target levels in the near term. Businesses can mitigate these risks by mapping their value chains, monitoring key indicators, and using advanced forecasting models to anticipate changes and adapt strategies accordingly.
