How supply chain constraints contribute to today’s inflation

August 5, 2022 | Market news

Key takeaways

  • Supply chain challenges have contributed to the recent surge in inflation.
  • A number of factors continue to limit supply in certain sectors of the economy.
  • While improvements have occurred, a variety of challenges need to be resolved to improve supply chain shortfalls.

The rapid rise in the inflation rate is a dominant concern for businesses, consumers and investors. For the 12 months ended in June 2022, living costs in the U.S., as measured by the Consumer Price Index, rose by more than 9%.1 It’s not just a domestic problem. Recent inflation spikes are a global phenomenon.

“Higher inflation today reflects a restricted goods supply at the same time there’s strong demand for many of those same goods,” says Tom Hainlin, national investment strategist at U.S. Bank. The most notable examples of restricted supplies revolve around energy and food products, related in large part to the war between Russia and Ukraine. These two goods played a significant role in driving up living costs in recent months.

Yet supply chain issues affecting a wider range of products are also contributing to the problem. Some manufacturers had difficulty keeping up with demand, sourcing components needed to manufacture products or finding enough workers to fill production needs. In addition, transportation challenges mounted, including a backup of shipping traffic in some ports and a shortage of truckers to haul freight over long distances.

How does this affect the current environment and what could it mean for the markets?

A pandemic casualty

As the world confronted the COVID-19 pandemic’s emergence in early 2020, the global economy came to a virtual standstill. To limit the spread of the virus, many businesses were forced to close except those that policymakers deemed “essential” services. At the same time, a number of governments implemented emergency policies, providing financial support to consumers and businesses to help them weather pandemic related economic challenges.

Household balance sheets improved with the support of these policies. Consumers, unable to spend money on services and leisure activities (such as eating out, visits to health clubs and travel) instead spent money on products ranging from cars to exercise equipment and home improvement projects. This resulted in a surge of demand in specific segments of the economy, often outpacing supply. Pandemic-related business interruptions limited production, leading to scarce supply of desired goods.

“Higher inflation today reflects a restricted goods supply at the same time there’s strong demand for many of those same goods.”

- Tom Hainlin, national investment strategist, U.S. Bank Wealth Management

It was during the early stages of this surge that supply chain issues began to develop. The impact on inflation first became evident in early 2021. Since that time, inflation pressures have intensified. The Federal Reserve (Fed) is attempting to address the issue by taking aggressive steps to cool demand, such as raising short-term interest rates. Yet Hainlin notes that the Fed has little control over the supply side.

Multiple factors contribute to supply shortages

Hainlin says there are several factors fueling the continuation of supply challenges. “We can divide this issue in three primary ways – what’s going on in China, issues across the global supply chain and what’s affecting supply within the U.S. itself.”

Chinese firms play a major role supplying parts or finished products that are popular among consumers. The Chinese government is pursuing a “zero COVID” policy, which results in shutdowns of major cities where infections appear. “This restricts production in manufacturing facilities and the flow of goods through Chinese ports as they try to stem the tide of COVID in a very strict way,” says Hainlin.

Production and shipping from other major manufacturing countries may be tied to economic expectations. “In countries like Taiwan and South Korea,” says Hainlin, “output is driven by a consensus view anticipating a worldwide economic slowdown, so many firms are more cautious about ramping up production.”

Hainlin believes domestic supply constraints are largely a function of labor shortages, as unemployment lingers near historic lows and job openings remain high. “The major challenge for many employers is whether they can attract and retain sufficient labor to meet their production demands.” Hainlin says this problem spreads from manufacturing facilities to airlines to transportation services like trucking and port operations.

War-related supply disruptions

Russia’s invasion of Ukraine, which began in late February 2022, immediately roiled energy and agricultural commodity markets. “The upward swing in oil prices is a direct result of the war and Europe seeking to impose restrictions on importing Russian oil,” says Hainlin. He points out that this impacts the global oil supply, as oil is priced on worldwide markets, and not just domestic production trends. “Bigger countries, for the most part, are net oil importers, so higher oil prices typically lead to a slowdown in aggregate economic growth,” says Hainlin.

Both Russia and Ukraine are major agricultural producers. After a long period of interruption, shipping of Ukrainian farm commodities to overseas destinations only recently resumed. African nations, among others, are highly dependent on Ukrainian crop production. The inability to ship products due to Russian intervention of sea lanes contributed to higher commodity prices. As a result, consumers across the world are paying more for food at the retail level. “The restrictions affecting the flow of oil and food are exacerbating the breadth of price increases,” says Hainlin.

The chip shortage

Another prominent story related to supply chain issues was the shortage of semiconductor components for various purposes. These “chips” play an increasingly important role in a variety of products. For most of the last two years, orders for chips have been backlogged, causing a delay in the production of a number of items. The most notable sector that’s been affected is the automobile industry.

“Semiconductor components are critical to automobile production today,” says Hainlin. “With production delayed due to a lack of available chips, the supply of vehicles dropped and prices rose.” Higher costs for new and used cars are another major contributor to the rapid increase in the overall inflation rate.

Most semiconductors come from firms based in Taiwan and South Korea. In late July, the U.S. Senate and House passed legislation incentivizing construction of domestic semiconductor manufacturing plants. It includes a commitment of $52 billion to support the development of the semiconductor industry in the U.S. “Countries are interested in establishing domestic capacity that can’t be challenged by another nation,” says Hainlin. “We saw a number of countries pass similar legislation in previous years promoting robotics development.”

Hainlin notes this is not a quick fix to current semiconductor shortages. “The challenge is that this is a sophisticated technology, and it may take some time to catch up with the largest firm in the world in this sector, Taiwan Semiconductor.”

What isn’t clear is the near-term demand for semiconductor chips. “It’s difficult to determine if the current high demand is related to manufacturers trying to get ahead on inventory, or if demand will continue to rise as it has in recent times,” says Hainlin. “These are the kinds of questions we’re dealing with across many sectors of the economy as we emerge from COVID-19, as supply chains begin to return to normal and as we get a better sense of what future demand looks like.”

Where we go from here

The sudden upturn in the inflation rate and its persistent nature demonstrates a continued imbalance between supply and demand, particularly in certain segments of the economy. The Fed’s aggressive policy reversal left behind its “easy money” approach that featured low interest rates and significant investments in the bond market. The Fed hiked interest rates rapidly over the spring and summer of 2022. “The Fed is sending a message to consumers that they will succeed in getting inflation back to normal,” says Hainlin. However, the Fed’s sudden turn played a role in the bear market for stocks that occurred in the first half of 2022. It also triggered lower bond prices as interest rates rose across the broader bond market.

The Fed’s actions are designed to dampen consumer demand, which will hopefully alleviate some of the supply side pressures. Hainlin believes the Fed will continue its rate hike policy until inflation numbers improve. Market participants are closely monitoring the Fed to see if it can achieve a tamer inflation environment without sending the economy into a recession. The confluence of interest rates, inflation and corporate profit growth are three key factors for investors to monitor in the closing months of 2022, as the rate of economic growth will likely be reflected in corporate earnings and stock prices.

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