When firms see an increase in demand for their products, they often interpret it as a signal of higher sustained future demand, and therefore decide to increase investments and expand production capacity.
With inflation at the highest levels in 40 years, the high cost of living and the rising price of goods have become top concerns for individuals, firms and economies.
For some firms, inflation is the result of an increase in demand that can originate from reasons that affect all firms, such as increases in the money supply or supply-chain bottlenecks (like during COVID and in the aftermath), or from firm-specific reasons, like a shift in consumers’ tastes.
When firms see an increase in demand for their products, they often interpret it as a signal of higher sustained future demand, and therefore decide to increase investments and expand production capacity. But Elia Ferracuti, an assistant professor of accounting at Duke’s Fuqua School of Business, says that in the presence of inflation this could amount to a misinterpretation of the signals that would lead to an inefficient use of the company’s resources.
Ferracuti told an audience on Fuqua’s LinkedIn page that managers might be unable to separate a permanent shift in consumer tastes from a nominal inflationary shock that won’t change the position of the firm relative to its competitors.
In a recent study, Ferracuti and co-authors Oliver Binz and Peter R. Joos of INSEAD explored how inflation affects managers’ investment decisions. They suspected that firms increase investments in inflationary times more than what an efficient use of resources would suggest, and that firms with superior internal information systems would be more protected from this inflation “illusion.”
“This is important,” Ferracuti said, “because investments drive improvements in productivity,” a crucial indicator affecting the performance and living standards of entire economies.
To test their hypothesis, the researchers studied a sample of approximately 5,000 firms distributed across 21 countries from 2004-2015.
Their findings showed a link between inflation and investment spending. “For each one percentage point increase in inflation, firms--say--with an asset base of 100 million will increase their investment by 1 million,” Ferracuti said.
Ferracuti said the researchers also discovered that a unit improvement in the quality of internal information systems mitigates the correlation between inflation and investments by a third.Also read: Will El Nino further heat up Indian macro and markets?
And consistently with their expectations, the researchers also found that the inflation/investment correlation negatively impacts the firms’ future profitability. “Inflationary shocks lead on average to lower future performance,” Ferracuti said, “and the effect is smaller for firms with better internal information systems.”
Ferracuti said the results are only applicable for firms without pricing power, companies operating in highly competitive markets who cannot afford raising prices without losing customers.
These findings do not necessarily reflect poor decision making from managers, but more likely indicate the existence of information frictions, namely the impossibility to know everything perfectly all the times. “Managers are not stupid,” Ferracuti said. “They make the optimal decision given the information available to them at any given time.”
“Put yourself in the shoes of those executives: They don't know whether their financials are driven exclusively by consumer tastes, exclusively by inflation, or the combination of the two,” he said.
Ferracuti said companies who adopt information tools like Enterprise Resource Planning (ERP) software, or Consumer Relationship Management (CRM) technologies are better equipped to understand the drivers behind their performance, and to make the correct investment decisions in response to inflationary shocks.
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Quoting a 2021 report by Accenture, Ferracuti said that organizations that embrace digital technologies to make faster, data-driven decisions have an opportunity to generate significantly higher value.
Quoting separate studies, Ferracuti also noted that there is a strongly positive correlation between the quality of internal information systems and the education of a firm’s managers and employees.
Ferracuti said his paper provides insights for firms, investors, lenders, and regulators. Investors and lenders can better assess the strength of a company by the quality of their internal information systems. Regulators like the FED will want to consider that the effectiveness of monetary policy on inflation will vary with the quality of the firm’s internal information systems.
[This article has been reproduced with permission from Duke University's Fuqua School of Business. This piece originally appeared on Duke Fuqua Insights]