Inflation Risk and Firm Production Cost

Abstract

Inflation risk is a significant concern, yet few effective hedges exist for overall inflation exposure. From a managerial perspective, inflation-induced cost pass-through has garnered increasing attention. This paper investigates the role of a firm's production cost structure on stock sensitivity to inflation. At first glance, my findings reveal a puzzling result: firms with high fixed costs exhibit negative exposure to inflation surprises, contradicting established literature. To address this puzzle, I uncover two critical insights. First, I find that variable costs dominate the cost structure, are negatively correlated with fixed costs, and are positively associated with inflation beta. Importantly, when controlling for variable costs, the inflation beta of fixed costs switches from negative to positive. However, this reversal does not occur for variable costs. These findings suggest that variable costs are the primary driver behind the negative inflation beta of fixed costs. Second, I observe that during periods of high inflation, customers tend to switch from high-margin firms (with low variable costs) to low-margin firms (with high variable costs) within the same industry, benefiting the latter. This customer behavior is more pronounced in industries with wider margin dispersion, lower customer loyalty, and higher levels of customer substitution, enabling greater price competition. Together these findings demonstrate that customer switching, triggered by inflation surprises and differing firm cost structures, affects stock sensitivity to inflation. Finally, I demonstrate that the inflation beta and risk premiums of portfolios sorted by production costs are inversely related, leading to the derivation of a negative unconditional price of headline inflation risk.

Keywords: asset prices, production cost, inflation

JEL Classification: G11, G12, E31