It’s baaaaack.
Noticed things are getting more expensive?
It’s inflation. Inflation is back, and with a vengeance. In essence, disruption to supply chains along with high demand means an increase in prices with a decrease in your purchasing power.
More buys less.
But you don’t want to have less for more, so this week we’re giving you seven things to protect you from inflammation via your negotiations and contracts.
Let’s first look at some causes of inflation, all of which ultimately deal with supply and demand:
small supply + equal/increased demand = inflation
My wife was on the East coast a few weeks ago when the local pipeline was hacked and shut down for a few days. In a panic, consumers rushed to gas stations, yielding long lines and gas prices well in excess of $3.00. High demand, low supply, exorbitant cost. Voila, inflation.
The most glaring cause right now is disruptions of supply chains due to fallout from geopolitics, worker shortages, pandemic and/or regulations. We’re seeing a shortage of computer chips now standard for cars, which slows down the production of new cars, putting both new and used automobiles in high demand, and at a higher price point.
Meanwhile, free trade is hampered by intense regulation, high fees, tariffs and taxes, which are ultimately paid by consumers. A hundred years ago when I was an econ student at Georgetown University, we used Econ Nobel Laureate Paul Krugman’s work. Although his predictions have been reliably and famously wrong, he is correct in his recent statements that middle and lower income earners are most negatively impacted by inflation. Similarly, small and middle market businesses, especially those in low margin industries, endure the heaviest losses.
So how do you protect yourself from the Tsunami of inflation we are seeing?
Here are SEVEN ways to negotiate clauses in your personal life and business to get a handle on cost:
1. Determine which Consumer Price Index (CPI) population group to use in your contract.
The CPI publishes price changes for two population groups: The Consumer Price Index for All Urban Consumers (CPI-U) and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). As the name implies, the CPI-U measures price change for urban consumers, while the CPI-W measures price changes for a narrower population of Americans. An escalation contract should specify whether the CPI-U or CPI-W is to be used. The CPI-U covers a significantly broader segment of Americans and represents the broadest measure of consumer inflation that BLS produces, therefore it is typically subject to less sampling error than the CPI-W.1
2. Determine which CPI item category to use in the contract.
CPIs are published for hundreds of item categories. There are separate indexes for bananas, medical care, and televisions, etc. The broadest item category is the “all items” category, which includes everything and anything a consumer buys out of pocket: food, fuel, clothing, housewares, cars… you name it. An escalation contract should specify which CPI item category is to be used in the escalation. Generally, users are encouraged to specify a broad item category, such as the all items index, when writing an escalation contract because broader item categories have larger sample sizes and are typically subject to smaller sampling error.
3. Determine which geographic area to use in the contract.
CPIs are published for a wide variety of geographic areas. For example, the U.S. Bureau of Labor Statistics (BLS) publishes indexes for the U.S. City Average (or national) level, the regional level (for example, the South region), and for some local metropolitan areas (for example, Atlanta, GA). An escalation contract should specify which CPI geographic area is to be used in the escalation. An advantage of specifying the broader (U.S. City Average) geography in the contract is that U.S. City Average indexes have larger sample sizes than smaller geographic areas do and therefore are subject to smaller sampling error.
4. Determine which reference base to use and how to handle potential changes in the reference base.
A reference base specifies which time period is set to 100 for an index. Defining a reference base of 100 allows users to more easily calculate percent changes over time. For each CPI index series, BLS publishes a current, or “standard” reference base. For example, the standard reference base for the CPI-U all items index is 1982– 1984=100. Some index series, though, have different reference bases. For clarity, an escalation contract should specify the reference base to be used.
The contract could also specify how to handle a change in the reference base. For example, before 1988, the all items index was published on a standard reference base of 1967=100. In 1988, the reference base of 1982–1984=100 became the standard reference base. Percent changes between periods are not affected by changes in the reference base (except for rounding). As such, an escalation contract could state that the standard reference base be used.
5. Use indexes that are not seasonally adjusted.
BLS publishes some indexes that are seasonally adjusted and some that are not seasonally adjusted. In an escalation contract, the parties should generally use an index that is not seasonally adjusted, and they should specify this in the contract. Seasonally adjusted indexes are subject to revision each year, so they add an unneeded level of complexity to most escalation contracts.
6.Specify a unique CPI index series.
In summary, the CPI population, item category, and reference base should all be explicitly stated in an escalation contract in order to spell out which CPI is tied to the contract. In addition, parties should note they are using indexes that are not seasonally adjusted. For example, if the parties wanted a contract to use the broadest measure of consumer inflation, they would write the contract to specify the precise index being used, as follows: The Consumer Price Index for All Urban Consumers (CPI-U); U.S. City Average; All items, not seasonally adjusted, 1982–1984=100 reference base.
7. Other considerations
Specify the base dollar amount. The two parties that are writing the escalation contract using the CPI should specify the base amount to be escalated.