Shifting the curve: How digital technology investments reduce inflationary pressure

Introduction

Inflation is a sustained increase in the general price level of goods and services over time. Economists have long studied the effects of inflation and deflation and major consensus indicates that a moderate level of inflation is ideal for economic growth as it encourages spending and investment (now, rather than later), it boosts wages and helps ease the debt burden on the economy. Many economists agree that the ideal value for inflation is around 2% - the target level set by most western central banking regulators (ECB - 2%, US Fed - 2%, BoE - 2,5%).

Left unchecked, inflation has negative effects on the economy since it reduces the purchasing power of consumers, reduces the competitiveness of businesses, and reduces the overall economic growth rate. When inflation is high, consumers have to pay more for the same goods and services, which reduces their disposable income and can result in lower levels of consumer spending. In addition, high inflation can cause businesses to raise their prices, which can reduce their competitiveness and lead to lower profits. This, in turn, can lead to lower investment, lower employment levels, and ultimately lower economic growth.

Historically we saw this during the 1970s in the United States, the United Kingdom, Portugal and Spain. Then in the 1980s and 1990s in South America, Argentina, and Brazil. And more recently, in the last decade, Venezuela was also financially impacted by rampant inflation. Each of these scenarios has distinct root causes and, also, required different sets of measures to help curb inflation.

To combat inflation, policy makers and regulators use traditional policy measures such as adjusting interest rates, managing the money supply, and controlling government spending. Adjusting interest rates can reduce consumer spending, as higher interest rates lead to higher borrowing costs. Monetary policy, can affect inflation by increasing or decreasing the amount of money available in the economy, thus affecting the overall price level. Tighter government spending control can also help to reduce inflation by reducing the overall demand for goods and services.

While these traditional policy measures are fundamental, much has already been written by far more competent people than myself on these matters, so I’d like to stick to what I know and explore how private sector investments in digital technologies can also contribute to a reduction of high inflation and help achieve long-term economic stability.

How is inflation calculated?

Inflation is typically measured as the percentage change in a price index over time - the Consumer Price Index (CPI). The CPI tracks the prices of a basket of goods and services consumed by households or businesses. The process is typically carried out by the national statistical agency and includes the following steps:

1.      Selecting the basket of goods and services: The national statistical agency selects a representative basket of goods and services that are typically consumed by households in the country. This basket includes thousands of items, ranging from food and housing to clothing and transportation.

2.      Collecting price data: The national statistical agency collects price data for each item in the basket on a regular basis, typically every month. The prices are collected from a sample of retail stores, service providers, and other sellers.

3.      Weighting the items: The national statistical agency assigns weights to each item in the basket based on its relative importance in the average household's spending. For example, the weight assigned to housing is typically much larger than the weight assigned to clothing.

4.      Calculating the index: The CPI is calculated as a weighted average of the prices of the items in the basket. The formula for the CPI is:

CPI = (Expenditure in the current period / Expenditure in the base period) x 100

where the expenditure in the current period is the total amount spent on the basket of goods and services in the current period, and the expenditure in the base period is the total amount spent on the basket in a previous period (usually a designated base year).

5.      Computing the inflation rate: The inflation rate is calculated as the percentage change in the CPI from one period to the next. For example, if the CPI in 2023 is 110 and the CPI in 2022 was 100, then the inflation rate for 2023 is 10% [(110-100)/100 x 100].

So, inflation is a function of the selection of a basket of goods and services and the price of those goods and services over a certain period of time, as well as the level of household expenditure on those same goods and services over the same period. Although technology can help with the selection of the basket of goods and services, that is a function of the national statistical agency, and ultimately not affected by private sector investment in digital technologies. So, we’re left with the impact of these investments on supply and demand and how those investments might affect the price of goods and services.

In economics, the market equilibrium price correlates demand, supply, and price. Market equilibrium in a free-market is achieved when the quantity demanded equals the quantity supplied. At this point, the resulting market price is called the market equilibrium price.

Where:

• Qd is the quantity of a good or service that consumers are willing and able to purchase at a certain price.
• Qs is the quantity of a good or service that producers are willing and able to supply at a certain price.

In equilibrium, the market clears, and there is no excess supply or demand. If the demand curve shifts to the right (left), indicating an increase (decrease) in demand, the equilibrium price will rise (fall). If the supply curve shifts to the right (left) , indicating an increase (decrease) in supply, the equilibrium price will fall (rise). Maintaining the balance or equilibrium between supply and demand is critical for price stability and controlling inflation. When supply and demand are in equilibrium, prices are usually stable, and inflation is low. However, when supply and demand are out of balance, prices can become volatile, which can lead to inflation or deflation.

Recent macro events such as the COVID-19 pandemic and the Russia-Ukraine conflict have generated ripple effects throughout the global economy that are pushing inflation up. The pandemic and the subsequent lockdowns have significantly affected the global supply and demand for goods and services. As a result, there have been shortages of goods and raw materials across various sectors, such as food, medical supplies, electronics, and automotive parts. This scarcity of goods has led to a rise in prices, as companies have struggled to meet demand, resulting in inflationary pressures in most markets. Additionally, the Russia-Ukraine conflict has compounded these effects by causing significant disruptions in supply chains, driving up prices of basic commodities such as food and energy even further, which typically account for a significant expenditure of the reference basket of goods and services. The net effect is rising inflation at an accelerated pace that is rapidly becoming persistently high.

The role of digital technology in combating high inflation

In an inflationary economic scenario, to start reducing inflation, requires a decrease in the growth rate of the money supply. While driving up base interest rates is fundamental, increasing supply is also a desired measure, as increased supply would help to alleviate upward pressure on prices and contribute to a more stable price level.

This can be achieved through measures such as promoting increased competition in markets, reducing barriers to entry for new firms, and increasing investment in infrastructure and technology. The effect of this latter measure on supply can be expressed in the quantity supplied as a function of the price of goods and services, the cost of producing said goods and services, and the level of technology available to produce and deliver the goods and services:

Qs = f (P, C, T)

Where:

• Qs is the quantity of goods and services supplied
• P is the price of goods and services
• C is the cost of production
• T is the level of technology available

Assuming that all else remains equal, an increase in the level of technology available would shift the supply curve to the right, leading to an increase in the quantity of goods and services available and a subsequent decrease in the equilibrium price.

The emergence and adoption of digital technologies such as cloud computing, big data, artificial intelligence, and the Internet of Things (IoT) have the potential to help drive down prices by moving the supply curve to the right. The following are some of the factors that can drive this change in the supply curve:

• Improved productivity: Digital technologies can enhance productivity by automating routine tasks, reducing the time and resources required to complete them. For example, artificial intelligence can be used to automate customer service functions, freeing up employees to focus on more complex tasks. In fact, Gartner predicts that by 2026 conversational ai will reduce contact center agent labor costs by $80 billion. This can increase the efficiency of firms and reduce production costs, leading to a shift in the supply curve to the right.
• Better supply chain management: Digital technologies can improve supply chain management by providing real-time data on inventory levels, shipment status, and demand. This can help firms optimize their operations, reduce waste, and improve delivery times. For example, Walmart uses big data to optimize its supply chain, reducing waste and improving efficiency.
• Increased competition: Digital technologies can lower barriers to entry and increase competition, leading to lower prices. For example, online marketplaces like Amazon and Etsy have increased competition in the retail industry, leading to lower prices for consumers.
• Economies of scale: Digital technologies can enable firms to achieve economies of scale by increasing production capacity and reducing per-unit costs. For example, cloud computing providers typically offer a pay-as-you-go pricing model, where companies only pay for the resources they use. This can help companies reduce their per unit costs by avoiding the need to over-provision computing resources.
• Increased resource utilization: Digital technologies can enable greater utilization of existing resources, thus lowering prices due to increased availability. For example, AirBnB leveraged digital technologies such as cloud and mobile computing to tap into the underutilized accommodation capacity in the world's cities. Uber and Lyft did the same by recognizing that the existing stock of motor vehicles is highly underutilized. Increased resource utilization leads to higher production (in the above examples more bookings or more rides) and, all things being equal, the price of the produced goods or services will fall.

In a high inflation and high-interest rate environment, digital technologies play a crucial role in reducing prices, acting as a deflationary force. The following are five digital technologies that can have a high impact in increasing supply and combating high inflation rates.

1. Data analytics and artificial intelligence

Data analytics and artificial intelligence can be used to analyze consumer behavior and market trends, allowing companies to adjust their pricing strategies to meet changing demand. By using predictive analytics, businesses can identify patterns and anticipate changes in consumer behavior before they happen. This can help them to adjust prices accordingly, ensuring that they remain competitive and reducing the likelihood of excess supply. Additionally, by using AI to optimize their supply chain, companies can reduce costs and improve efficiency, allowing them to pass on savings to customers in the form of lower prices.

Financial benefits:

• Lower prices may increase consumer demand, leading to increased sales and market share.
• Companies that can operate more efficiently may be able to offer lower prices while maintaining profitability.

Macroeconomic context caveats:

• A reduction in prices may have deflationary effects on the wider economy, potentially leading to lower wages and increased unemployment.
• If businesses are unable to operate more efficiently, they may not be able to offer lower prices without reducing their profitability.

Operational challenges:

• Accurately predicting consumer behavior and market trends can be challenging, and incorrect predictions may lead to excess supply or missed sales opportunities.
• Implementing AI and data analytics solutions may require significant investment in technology and training.

2. Automation

Automation can help to reduce costs by streamlining production processes, improving efficiency, and reducing waste. This can lead to lower prices for consumers as companies are able to produce goods at a lower cost. Additionally, automation can reduce the need for manual labor, which can be particularly useful in industries where labor costs are high.

Financial benefits:

• Lower production costs can lead to lower prices for consumers, which may increase demand and sales.
• Automation can reduce labor costs, which can increase profitability for companies.

Macroeconomic context caveats:

• Automation may lead to job losses in industries where labor is being replaced by machines.
• A reduction in labor costs may lead to lower wages and reduced spending power for workers.

Operational challenges:

• Implementing automation solutions can require significant investment in technology and may require a significant change to production processes.
• The benefits of automation may not be immediately realized, as companies may need to invest in new technology and training before they can see the full benefits.

3. Cloud computing

Cloud computing can help to reduce costs by allowing businesses to host data and applications remotely, rather than investing in expensive on-premise infrastructure. This can help to reduce the costs associated with IT maintenance, upgrades, and support. Additionally, cloud computing can improve collaboration and communication between teams, which can improve productivity, further reducing costs.

Financial benefits:

• Reduced IT costs can help businesses to offer lower prices to customers, which may increase demand and sales.
• Improved collaboration and communication can improve productivity and reduce costs.

Macroeconomic context caveats:

• While cloud computing can reduce costs for individual businesses, it may lead to consolidation in the industry as larger companies are better equipped to take advantage of cloud computing technology.
• If cloud providers are located outside domestic borders, it may lead to a reduction in tax revenue for local governments.

Operational challenges:

• Implementing cloud computing solutions may require significant investment in technology and training.
• Businesses may need to ensure that their cloud provider is reliable and secure, to avoid data breaches or other security issues.

4. Big data

Big data can help businesses to make more informed decisions by providing insights into customer behavior, market trends, and operational efficiency. This can help businesses to identify areas where they can reduce costs and improve efficiency, which can lead to lower prices for consumers.

Financial benefits:

• Predictive analytics can help companies optimize their production, inventory management, and distribution processes, resulting in cost savings and potentially lower prices for consumers.
• Big data can help retailers personalize promotions and offers, which can increase sales and customer loyalty. Better targeting of the customers most likely to respond to promotions and offers, reduces waste and maximizes ROI.

Macroeconomic context caveats:

• The use of big data can lead to economic concentration, where a small number of companies control the majority of the data and the benefits from its use. This can lead to market power and reduced competition, which can result in higher prices and reduced consumer welfare.
• Privacy and data protection. The use of big data to analyze consumer behavior could be seen as invasive by some consumers. Companies and governments need to ensure that they are transparent about how they are using data and are compliant with relevant regulations.

Operational challenges:

• Collecting and analyzing large amounts of data can be a significant operational challenge. Companies need to invest in the right technology and talent to manage big data effectively.
• Big data analysis is not a one-time process. Companies need to continually collect and analyze data to stay ahead of changing market conditions and consumer behavior.
• Big data analysis can be complex and require specialized knowledge. Companies need to ensure they have the necessary expertise in-house or partner with external experts to maximize the benefits of big data analysis.

5. Internet of Things (IoT)

The Internet of Things (IoT) is a network of physical devices, vehicles, home appliances, and other items embedded with electronics, software, sensors, and connectivity, enabling them to collect and exchange data. In the context of managing inflation, IoT can provide valuable insights into supply chain dynamics, production processes, and inventory management. Here are some financial benefits, macroeconomic context caveats, and operational challenges associated with using IoT to manage inflation:

Financial Benefits:

• Improved supply chain efficiency: IoT devices can monitor the movement of goods and raw materials in real-time, providing accurate data on inventory levels, production rates, and delivery times. This can help optimize supply chain processes, reducing waste and increasing efficiency, ultimately leading to cost savings.
• Better demand forecasting: IoT sensors can monitor customer behavior, product usage, and market trends, providing valuable data for demand forecasting. This can help companies produce goods in a more targeted and efficient manner, reducing the likelihood of overproduction and waste.

Macroeconomic context caveats:

• Privacy concerns: The collection and exchange of personal data through IoT devices can raise privacy concerns, with potential negative implications for consumer trust and public policy.
• Unequal access: The adoption of IoT technologies may not be evenly distributed across industries and countries, potentially leading to uneven financial benefits across sectors, reducing impact on the CPI basket of goods and services.

Operational challenges:

• Integration complexity: IoT devices may need to integrate with existing systems, requiring additional investments in technology and infrastructure.
• Data management: The massive amounts of data generated by IoT devices may require advanced analytics capabilities and storage solutions.
• Standards and interoperability: The lack of standardized protocols and interoperability between IoT devices may create compatibility issues and impede adoption.
• Cybersecurity risks: The interconnectedness of IoT devices can expose companies to cyber threats, potentially leading to data breaches, production disruptions, and reputational damage.

The importance of passing down efficiency gains

To ensure that the use of digital technologies leads to lower prices, companies must pass down the efficiency gains obtained from these investments to customers. As we saw, these efficiency gains can come from a variety of sources, such as automation, reduced waste, and improved supply chain management, all of which can reduce the costs of production. If companies do not pass these cost savings down to consumers, the benefits of these technologies may not be realized, and prices may continue to rise despite the implementation of new technology.

Furthermore, if companies fail to pass down the cost savings, they may risk losing their competitive edge. Customers are likely to switch to competitors who offer lower prices, especially in a high inflation environment where consumers are highly sensitive to price changes. Companies that do not take advantage of digital technologies to improve operations and reduce prices risk being left behind, as competitors who do will be able to sell their products at lower prices while still being profitable.

So, CEOs need to prioritize technology investments in their company’s strategy agenda, CIOs need to prioritize delivery of tangible operational cost savings from the technology investments being done, and CFOs need to prioritize not only capital investment for these initiatives, but also that the benefits realized from them are passed down to consumers. Doing so, will not only benefit the broader economy but also improve the company’s competitiveness in the market.

Conclusion

The COVID-19 pandemic and the ongoing Russia-Ukraine conflict had a significant impact on the global economy, leading to rising inflationary pressures in many markets. The pandemic disrupted global supply chains, causing shortages of goods and services, while the conflict has led to rising commodity prices, particularly energy prices. These factors contributed to increased production costs, which have been passed on to consumers in the form of higher prices, driving inflation to levels that hadn’t been seen in decades.

To address these inflationary pressures, policymakers have a range of measures they can implement, including raising interest rates, increasing income tax and reducing government spending. On the private sector side, investment in technology is one of the best ways to help drive down inflation to sustainable levels, as it can increase productivity, efficiency, and innovation of individual firms, reduce barriers to entry and improve competition in the market. By using digital technologies such as cloud computing, big data, artificial intelligence, or Internet of Things (IoT), firms can streamline their operations, reduce costs, and increase output, which can shift the supply curve to the right and lower prices for consumers.

Investing in technology can be challenging for firms, particularly in a high-interest rate environment where the cost of borrowing is higher. Firms may also face challenges in finding skilled labor or navigating regulatory challenges. However, making these investments now can provide efficiency gains in the short-term and position firms to better compete in the future. CxOs can take several short-term actions to contribute to taming rising prices:

1. CIOs can review their existing technology infrastructure and to identify areas where digital technologies, such as cloud computing or artificial intelligence, can be leveraged to improve operational efficiency. This can help firms reduce costs and increase productivity, which can lead to lower prices for consumers.
2. CFOs can prioritize technology investments that will drive increased efficiencies and, then, ensure that the gains from those efficiencies are passed down to consumers in the pricing structure.
3. CHROs can invest in employee training and development to ensure that their workforce is equipped with the necessary skills to leverage these technologies effectively.
4. CEOs can explore partnerships with technology firms or start-ups to access the latest innovations in digital technology.

In short, while investing in digital technology may present challenges in the short-term and may almost seem counterintuitive, firms that take action now can benefit from increased efficiency, productivity, and competitiveness in the long run. By adopting digital technologies and investing in their workforce, firms will not only help tame rising prices and drive the economy towards sustainable target inflation levels, they will also become best positioned to compete more effectively and better leverage the next growth cycle.

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