A nonfactor for decades, inflation is now parsed into demand pull and cost push

Pricing analysts across the tech industry will have to take a new look at the mix of inflationary pressures, sort those pressures by cost push and demand pull, and adjust their own business muscle memory for both short- and long-term instability stemming from rising energy costs, destabilized supply chains and increased component demand.

 

To excel at textbook economic analysis, you are told to look at one variable, “all other being equal,” or ceteris paribus. But the real world never works that way. The real world becomes particularly alarming for economists when their textbook explanations are not borne out by what is happening.

 

Such a situation occurred in the late 1970s. Inflation (and unemployment) increased from 7.5% to 10.4% from Jimmy Carter’s presidency to Ronald Reagan’s presidency, and then chair of the U.S. Federal Reserve Paul Volcker began raising interest rates to choke off inflation. The term “stagflation” was coined to explain the inexplicable. As we seek to understand inflation today, we have a better parsing of the multiple factors that can drive inflation.

Demand pull inflation: The classic definition

Demand pull inflation is classic 20th century thinking. It loosely corresponds to “too many dollars chasing too few goods.” Traditional Keynesian economic thinking asserts that this situation means the economy is overheating. It asserts the solution is for central banks to raise interest rates to slow demand and bring it in line with current supply. Low unemployment is expected to be a compatible condition to this kind of economic overheating, and with the slowdown, labor market pressure will likewise abate.

Cost push inflation: A fancier definition for resource scarcity (and potentially disruption)

Cost push drove the high inflationary cycle of the 1970s. Oil price shocks, driven by OPEC production decisions, triggered choke points across the entire economy. Companies had little recourse but to pass along price increases, or to “push” the costs onto the consumers at a time when unemployment was high.

The current blend of demand pull and cost push

Today demand pull influences are seen more on the consumer side, with record-high savings during the pandemic shutdown, plus consumer purchases and housing prices spiking due to various government relief payments. Similarly, unemployment remains low, and certain skilled positions, especially acute in the tech sector, remain hard to fill.

 

Textbook moves to raise interest rates to slow the economy are being deployed to cool this economic overheating. Whether it results in a soft or hard landing of the economy on more stable ground remains open to, at times, contentious debate, given cost push inflation is also rampant.

 

Cost push is readily apparent in any purchases of basic staples. Energy and food are about as basic as it gets, and there are no simple solutions to those issues. Energy is a heavily regulated industry, with public support for moving away from fossil fuels mounting, especially among younger individuals. Food prices are being hit by both the energy cost increases and the supply chain disruptions resulting from the conflict in Ukraine. Neither fuel nor food disruptions are likely to abate soon, and the food issues around wheat and the attendant products manufactured from wheat are likely to worsen before they improve.

 

If that news is not dire enough, energy supply chain constraints do not appear to be a short-term blip on the way to resuming normal productive capacity. A Grid News article lays out in great detail the supply chain constraints — rising demand, conversion of refinery capacity to renewable diesel, and shuttering of older domestic refinery capacity during the pandemic —impacting the refinery segment.

 

Further, expansion of U.S. refinery capacity is unlikely given regulatory and environmental risk, as well as a fundamental shift in financial outlook. The article expects gas prices to rise over the summer, which is a normal occurrence, but the article is not optimistic about an increase in refining capacity in the U.S. due to cost, environmental regulation, and long-term industry outlook as public sentiment grows for green alternatives.

What does this mean for the technology industry?

Within the tech sector multiple inflationary influences apply pressure. Rising energy costs will often be remediated with temporary surcharges. Amazon indicated in the company’s last earnings call that it was considering such measures. This surcharge can work for finished goods; however, component shortages triggering demand pull inflationary pressures similarly have a blend of cost considerations.

 

Some cost spikes will work themselves out as supply chains react to pandemic-induced disruptions. Other cost spikes will persist until productive capacity increases, given how many more finished goods outside of the technology space itself consume embedded components in smart devices.

 

For infrastructure manufacturers, this means year-to-year price declines in the “faster, better, cheaper” trendline, predicated on Moore’s law for decades, should at least temporarily flatten out. TBR analysis of the silicon shortages suggests these challenges will be ameliorated in the next two to three fiscal quarters.

 

The other pressure and risk consideration will be the impact on long-term pricing agreements for managed services and “as a Service” subscriptions. A backlog of recurring revenue priced with lower inflation forecasts will likely apply margin pressure to developing “as a Service” revenue streams of pure play companies and independent operating units within multiline businesses. Pricing adjustments may be baked into new agreements and renewals moving forward, but the runoff of booked contractual commitments could impact profit margins. Noncurrent bookings will be a telling indicator.

 

Services firms basing project fees on billable hours should be reasonably well insulated given hourly rates can change in real time to adjust for rising labor and fringe expenses.

 

As stated, pricing analysts will have to take a new look at the mix of inflationary pressures, sort those pressures by cost push and demand pull, and adjust their own business muscle memory for both short- and long-term instability rising energy costs, destabilized supply chains, and increased component demand brings to bear on their respective market segments and the monitoring of their commercial offers.

In TBR’s latest Global Delivery Benchmark, one particular number leapt out as both surprising and indicative of the sustained battle for technology talent.

If the conflict in Ukraine remains hot, labor unions may kick into higher gear, extracting additional concessions and making it more costly for companies to exit any European market.

What happens in Dubai … well, happens everywhere

On March 1, PwC Dubai hosted a LinkedIn webcast, “Transforming Our Region,” featuring commentary by Stephen Anderson, PwC Middle East markets leader; Richard Boxshall, PwC chief economist for the region; and Hanan Abboud, a partner in PwC’s International Tax & M&A practice. This latest episode of the webcast series, which started in the summer of 2020, included three main themes, two of which likely resonate strongly outside the Middle East region.

Global inflation can be a drag, but regionally not so bad

First, Anderson and Boxshall noted recent regional economic growth and an overall positive picture, particularly as the pandemic begins to wane, but cautioned about inflation as a damper in the near term, with a critical caveat: Many of the global inflationary pressures and trends have been more muted in the Middle East, particularly within the economies of Saudi Arabia and the United Arab Emirates (UAE). Boxshall reported that inflation has been relatively low and well managed locally, at around 2% for the region, but varies widely across countries.

Like elsewhere, energy prices and supply chain snafus drive most of the inflationary concerns and effects in the Middle East, but high oil prices act as a double-edged sword for some of the most important regional economies, as more money flows into government coffers while demand is put at risk of being suppressed in the long run. Overall, PwC reported on the cautious sentiment in the region as the business leaders it surveyed see inflation elsewhere and hope for sustained smart economic stewardship to keep inflation low in the region.

Cybersecurity tops concerns

Investment and innovation comprised a second regional trend with global echoes, primarily because of the main concern about what could hold back growth: cybersecurity risks. According to Anderson, cybersecurity generated more worry among Middle East business leaders than geopolitical tensions or lingering pandemic-related healthcare risks. Notably, PwC’s survey did not factor in Russia’s invasion of Ukraine, which could bring geopolitics to the forefront. In TBR’s view, consultancies like PwC that can address clients’ cybersecurity concerns in concert with offerings around innovation, transformation and sustainability will continue to outpace cyber-centric or niche vendors as client leaders increasingly appreciate the business value of integrating cybersecurity into enterprisewide strategy.

Joining the global movement toward 15% tax rate

The last development PwC highlighted will have the greatest near-term effect in the UAE but bodes well for global economic growth and regional good governance. Anderson and his colleagues noted that the UAE became the first country in the region to announce plans to adhere to Organization for Economic Co-operation and Development (OECD) guidelines by instituting a 15% minimum corporate tax rate. With the country planning to implement the 15% tax rate effective June 1, 2023, and the local business corporate tax rate capped at 9%, PwC acknowledged plenty of unknowns and expects plenty of exemptions. But overall UAE is continuing its decades-long efforts to keep the country economically attractive and closely intertwined with the global economy.

Advising clients on adjustments to the new 15% tax rate, to include navigating free-trade-zone rules, will provide near-term opportunities in the UAE and longer-term revenues as other regional governments adopt similar tax structures. For PwC, a new UAE tax regime aligns perfectly with PwC’s The New Equation strategy and emphasis on trust, transparency and global interconnectedness. As TBR noted in November, “Globally, PwC partners were leaning into the trust and leadership components of The New Equation and finding clients receptive to, and even welcoming of, PwC’s efforts to ‘peek around the corner’ at trends, challenges and opportunities on the near and far horizons.”

Don’t bet against the Emirates

In TBR’s estimates, PwC’s 2021 management consulting revenues in the Middle East topped $670 million, roughly one-third of the firm’s APAC revenues but growing faster than any other PwC region. Inflation spikes and cybersecurity strikes may slow that growth, but a more likely scenario is that the UAE, the Kingdom of Saudi Arabia and other regional economies will maintain their rapid growth as their booming talent pools and friendly tax and corporate governance structures continue to draw investments and continue to create opportunities for consultancies like PwC. I served in Dubai, UAE, as a foreign service officer for the State Department in the late 1990s and know it’s a fool’s bet to think the UAE won’t, eventually and sometimes in surprising ways, do exactly what they say they’re going to do.