Inflation and Aviation
It is becoming clear that inflation is a real challenge for organizations and individuals within the aviation industry. In previous articles, we have detailed the effects of inflation and economic uncertainties on specific segments, key stakeholders, and the aviation industry. For more on this see these articles: ‘3 Ways Aviation Businesses Are Coping With Inflation’, ‘The Aviation Industry and Economic Uncertainties’, ‘Inflation: Higher costs and their effects on Flight Schools’, ‘Inflation: Rising prices and its effects on pilots and their training’, ‘High Interest Rates/Cost of Borrowing and Their Effects on Aviation Businesses’, ’Debt: Its effects on the Aviation Industry’, ‘Economic Crisis and the Aviation Industry’.
In this article, we want to look at inflation more broadly and analyze what higher prices for consumer and capital goods mean in general for the aviation industry.
- What is inflation: In its most basic form, inflation is an increase in the money supply within an economy, and manifested in higher prices of goods and services when it comes without a commensurate increase in goods and services, leading to “price inflation”.
- Why so much inflation now: Unknown to many, the money supply has been increasing steadily for over a decade. And that increased supply is now working its way into goods and services.
- What can be done about inflation: To solve inflation one must take away the main cause, which is the increase in money supply. However, individuals and businesses directly or indirectly affiliated with the aviation industry can do specific things to mitigate the effects of inflation. It is worth noting that this will not stop inflation but help individuals and businesses to cope with it.
What is Inflation? (revisited)
Let’s start first by revisiting the definition of inflation. According to The Mises Institute Inflation is defined as, “when a government increases the quantity of paper money, the result is that the purchasing power of the monetary unit begins to drop, and so prices rise”. Also, according to Investopedia, Inflation is the decline of purchasing power of a given currency over time. In simple terms, inflation is the sudden or gradual increase in the general cost or price of goods and services. It is worth noting here – without getting too technical – that there can be inflation without a commensurate increase in prices of capital or consumption goods and services. Notwithstanding this, over time, inflation will find its way into the prices of goods and services.
Why so much inflation?
After all that has been said above, the logical question to ask is: Why so much inflation? Recently in the news and on social media, one can find myriad reasons for the recent spike in inflation. When we initially wrote about inflation in our article ‘3 Ways Aviation Businesses Are Coping With Inflation’ Seven months ago, inflation rates were much lower than today. Seven months ago, according to The Bureau of Labor Statistics (BLS), the current consumer price index (CPI) was at 6.9%, while the producer price index (PPI) was at 8.63%. Today, the CPI sits at 8.6% while the PPI is now at 10.8%. This means that for businesses, including flight schools and aviation businesses, on average the cost of the raw materials and inputs to do their business has gone up by 10.8% relative to the same time last year, while the prices paid for consumers to acquire their goods and service have gone up 8.6%.
The quick overview of the numbers above is important as we try to answer the question, “Why so much inflation?”. For a quick lesson in economics 101, here’s what causes inflation at its core:
The supply of money: The most basic principle of economics – supply and demand – states that the more demand for any item within an economy, given that the supply cannot catch up to the magnitude of the demand, then the price paid – in money, time, or any other medium of payment – must increase as a result. In our modern economy it is money that is used as payment for things. If the supply of money is increased – leading to increased demand – without a commensurate increase in the supply of things then ultimately one will need to pay more for those things.
Limited supply of goods and services: Over the past two years (2020-2022) beginning with the lockdowns after the pandemic hit, supply chains have been shut down, and companies and businesses that provide goods and services were largely not allowed to do business in an aim to slow the spread of the virus. At the same time governments around the world were providing citizens with the money necessary to stay afloat while not being able to work – producing goods and services. Now, with a relatively increased supply of money and the lack of production of goods and services, there is more money chasing less goods and services. This inevitably must lead to higher prices.
Inflationary policies: Since the early 2000s and particularly after the great recession in 2008, governments around the world believe it’s important to have inflation rather than deflation. For governments they believe that deflation is bad for an economy and inflation is important for growth. Therefore, governments have always targeted a particular amount of inflation each year. For the United States that’s 2% at one point and recently it’s an average of 2% over time. It is this author’s belief that there’s nothing wrong with deflation. In fact when the price of goods and services decline the standard of living of individuals within a society increases, and sound economic principles support this belief.
Why high Inflation now?
By now the reader should understand that what we consider to be price inflation starts simple and benign as an increase in the money supply. As stated above, since the early 2000s the money supply in the United States has been increasing steadily, with a dramatic acceleration of this increase starting in 2008 with what is known as quantitative easing (QE). Initially, most of this money supply went into assets such as stocks, bonds, properties, etc. However, over time it slowly worked its way into consumer and production goods and services. Initially, when the money supply within the U.S. economy was being increased, the increased supply found its way primarily into the stock market and the bond market, therefore, the price inflation that we are experiencing today was not a factor since the money supply had not yet worked its way into capital or consumption goods and services.
During the pandemic, The United States and governments around the world provided their citizens with money – an increase in the money supply – which was used to buy goods and services. This new money was different from the past, since it was not placed largely into investments such as stocks, bonds, and real estate, but was given directly to consumers to spend on consumer goods and services within the economy. Ultimately, injecting price increases directly into the market. One more difference between the increase in money supply during the pandemic and prior to the pandemic was the magnitude of increase. Not only was the supply of money given directly to consumers to spend on consumption goods and services. In just two years, the amount of money supplied was roughly equal to the total amount supplied to the economy over the prior 12 years.
Source: FRED – Board of Governors of the Federal Reserve System (US)
How long will high inflation last?
Here’s another basic economic principle; if there is a distortion In an economy that can lead to undesirable outcomes, the longer the distortion lasts, the more dramatic the outcomes. Therefore, for decades we’ve been increasing the money supply in the country which ultimately leads to higher inflation. Since the distortion – the increase in money supply without a commensurate increase in the production of goods and services – has been so large in magnitude and over such a long period of time, needless to say the effects of those distortions will last for a long time as well. How long, however, is not particularly known. Yet, what is known is that the distortion must work itself out to bring the system back to some sort of relative equilibrium between the supply of money and the supply of goods and services within the economy.
What can be done about inflation?
In thinking about what can be done about inflation we will discuss possible actions from three perspectives: government action, aviation businesses action, and individual action.
Government action: We constantly hear the government and the Federal Reserve talk about the various tools that they Will deploy to deal with rising inflation. By this they mean the rising cost of goods and services both for businesses and consumers. We will not dive into the merits of their tools and how effective they are. However, what we will say here is that the easiest way to deal with rising inflation is to reduce the supply of money in the economy by the government and or the federal reserve or at a minimum keep the money supply stable while increasing the amount of goods and services available for sale.
Aviation businesses action: In our article ‘3 Ways Aviation Businesses Are Coping With Inflation’, we detailed some actions aviation businesses can take in dealing with high inflation. In another article ‘Inflation: Higher costs and their effects on Flight Schools’ we also talk in detail about how aviation businesses can mitigate some of the effects of inflation down to the way they calculate profits and losses, and the assets on their balance sheets. These insidious effects are so detrimental to aviation businesses who generally carry large assets and operate at such low margins, that we will reproduce the analysis below.
Fictitious profits: Schools may easily mistake the increase in price paid by the customers for increases in profits. However, the input factors that go into those increased prices also increase the price the next time those same factors need to be replenished for future service. This term is helped examined along-side the concept of fictitious capital, which is summarized in the Morning Star’s article, ‘What is ‘fictitious capital’?’. An example might be helpful to illuminate this point further; If a school makes $100,000 in revenue in one month with a 10% profit margin, then the school would make $10,000 in profit for that month. Due to increased prices from inflation, perhaps 10% of customers paid more for the same service provided. Now, the school has $110,000 in total revenue. — If we use the original 10% profit margin the school might believe they now have $11,000 in profit. However, this increase is due to inflation, which means that the input factors for providing these services in the future will also increase. If the school were to treat the additional $1000 as profit; it would actually be consuming its own capital. That ‘extra’ $1000 will be needed to pay for the input factors for the next month’s services. To front-run inflation what schools may do is anticipate the inflationary amount for the future and raise prices in the present to accommodate for the inflation to come. Of course, this will need to be taken into consideration alongside the other factors such as competition. If competing companies are not also raising prices then this may not be the best approach to consider.
Accounting for depreciation of assets:Accounting for depreciation can be quite tricky in an inflationary environment. Very few business owners or operators today have had to operate in a high inflationary environment. Accounting for depreciation of assets must be carefully considered when dealing with inflation. For instance, say a flight school has an aircraft that is worth $1 million. Over a period of 20 years, that aircraft needs to be depreciated by 5% per annum. This means that every year the school depreciates the aircraft on its balance sheets as being used by $50,000 annually – given that a straight line depreciation methodology is used. Considering that inflation is 10% per annum, this complicates how depreciation is going to function. With inflation going up by 10% the depreciated value amount will need to be changed to keep up with the usage, all the way through the disposal of the asset throughout the next 20 years. If only 5% is used for depreciation then the asset will last 22 years which may distort the accounting principles. In order to have the asset last 20 years with a 10% inflation since the asset was purchased, it will need to be readjusted for inflation and then depreciated by 5.5% per annum instead. This whole process can be complicated, because inflation may be fluctuating either upward or downward and then this adjustment will need to be made constantly which is highly impracticable. This is why inflation will affect a flight school’s assets on its balance sheet most significantly because it will distort the accounting calculations. Depreciation calculations determine the portion of an asset’s cost that can be deducted in a given year. Depending on the method used, the amount may be the same every year. Or, it may be larger in earlier years and decline annually over the life of the asset.
Individuals (pilots, aviation customers/clients) action: In a previous article, ‘Inflation: Rising prices and its effects on pilots and their training’, we detail how inflation affects the individual pilot in pilot training and provide some useful tips in dealing with inflation. In another article, ‘Economic Crisis and the Aviation Industry’, we detail how rising prices could affect how consumers and clients in the aviation industry are affected by high inflation and economic uncertainties, and what can be done to compensate for higher prices.
Based on the arguments laid forth in this article, unfortunately, it is expected that inflation will get worse before it gets better. Some even believe that coupled with inflation there will be a recession and even a depression. We discuss this point in our article ’Debt: Its effects on the Aviation Industry’. What we do know for sure, is that the distortions that are caused by increasing money supply without a commensurate increase in the supply of goods and services are still yet to completely work their way out of the economy. To compound the problem the money supply within the economy is still being increased. This will have long-lasting and devastating effects on aviation businesses and individuals working in and purchasing goods and services that are directly or indirectly related to the aviation industry.
In this article, we did not go into detail in providing how aviation businesses can cope with higher inflation and what to do moving forward, as we have provided this in previous articles and will be doing so in other articles to come. However, aviation businesses will need to work harder to figure out best practices, tactics, or even strategies in dealing with inflation that may be coupled with a recession in order not only to survive but thrive throughout an inflationary economic environment.
Here’s what we do know, the aviation industry is needed now and into the future, and whatever it takes it will need to be here to provide those much-needed essential services to individuals and companies globally. It is also known that the aviation industry is paradoxically fragile in many ways, while extremely resilient in others. Therefore, it will get past this time and be tempered by the challenges it faces and come out on the other hand stronger and more prosperous than ever before.
Thank you for reading this week’s On Aviation™ full article. In general, how do you think high inflation and economic uncertainties will impact the aviation industry? Please share your thoughts in the comments below and remember to continue the conversation on our Twitter and Instagram.
Orlando – On Aviation™