How do supply chain issues contribute to inflation?

While still elevated, the pace of rising inflation has slowed this year. Improvements in the supply chain are likely helping lower inflation, from a 9.1% rate for the previous 12-month period as of June 2022 to 4.0% for the year ending May 2023. Supply chain bottlenecks were a major concern during inflation’s surge that began in early 2021.

As consumer demand rebounded following an economic “shutdown” phase of the COVID-19 pandemic, the global economy faced a shortage of commodities, parts or products that resulted in a supply-demand imbalance, forcing prices higher.

“Higher inflation reflected a restricted supply of goods at the same time that there was strong demand for many of those same goods,” says Tom Hainlin, national investment strategist at U.S. Bank. Energy and food products were leading drivers as inflation soared. The war between Russia and Ukraine exacerbated the challenges. Russia is a major energy supplier and both countries are major agricultural exporters. For a time, the war interrupted some shipments of commodities from both Russia and Ukraine. China’s dramatic COVID-19 lockdown policies, which were in place for an extended period of time, hampered manufacture and shipment of goods from Chinese firms.

Yet supply chain issues affecting a wider range of products also contributed to the problem. Some companies 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.

For the most part, the worst of these challenges have subsided. Supplies to manufacturers have improved and consumers are finding most goods readily accessible. In addition, the economy has transitioned from one driven by demand for goods to an emphasis on services, including travel and entertainment.

Are supply chain issues fully resolved and what could it mean for the markets?

A pandemic casualty

Supply chain issues first emerged early in the 2020 COVID-19 pandemic. Governments forced many businesses to temporarily close to limit the spread of the virus, except those deemed “essential” services. At the same time, emergency government policies provided financial support to consumers and businesses to assist them through the pandemic’s 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 directed their discretionary cash toward goods, such as exercise equipment, home improvement projects and new homes to adjust to the ‘work from home’ culture. This surge in demand for specific segments of the economy outpaced supplies. Pandemic-related business interruptions limited production, creating a scarcity of desired goods.

During the early stages of this surge, supply-chain issues developed, exacerbating a supply-demand imbalance and pushing costs higher. Accelerating inflation emerged in early 2021 and issues intensified into 2022. In March 2022, the Federal Reserve (Fed) took aggressive steps to cool demand, such as raising short-term interest rates. While that effort sought to dampen spending on the demand side of the equation, Hainlin notes that the Fed had little control over the supply side.

Commodities markets adjust

Over time, aspects of the supply-chain situation improved, and became less of a hinderance to the global economy. This was evident in broader commodity markets by the end of 2022. For example, in the spring of 2021, there were significant shortages of building materials, hindering construction of new homes and remodeling projects for existing homeowners. That drove prices of lumber and other materials dramatically higher. Since that time, according to surveys of contractors in the construction trades, availability of some products, including lumber, showed substantial improvement.¹ As supplies improved, prices came down. Publicly traded lumber futures contracts, which topped out at more than $1,500/thousand board feet in May 2021 and remained as high as $1,400/thousand board feet in early 2022, dropped to $373.70/thousand board feet by the end of 2022 and even lower since.²

Similar trends occurred in the energy sector. The price of a barrel of crude oil topped out at $123.70 in March 2022. For a period of several months, Americans paid much higher gasoline prices than they had over the prior two years. However, President Biden released some of the nation’s Strategic Petroleum Reserve to boost supplies, demand eased and fears of a Russian supply crunch subsided, helping bring prices down. As of late June 2023, oil stood near the $70/barrel range, a drop of 44% from its peak.³

“While oil supplies aren’t plentiful for a variety of reasons, prices have remained moderate and there may not be much of a catalyst for them to move significantly higher before the end of 2023,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “We are watching production cuts, primarily by Saudi Arabia, and plans for the U.S. government to refill the Strategic Petroleum Reserve.” The nation’s oil reserve was depleted to help boost oil supplies and bring prices down from their peak.” Still, Haworth says demand for oil is modest as well, which is helping to keep prices in check.

Chip shortage

Another prominent story related to supply chain issues was the so-called “chip shortage” referring to a lack of semiconductor components for various purposes. Chips play an increasingly important role in a variety of products. Dating back to late 2020, orders for chips were backlogged, causing a delay in the completion of many products. The most notably affected sector 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 were another major contributor to the rapid increase in the overall inflation rate. The chip shortage has since eased.⁴

Most semiconductors come from firms based in Taiwan and South Korea. In the summer of 2022, President Biden signed the CHIPS and Science Act into law, 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. “New factories are under construction in the U.S.,” says Haworth, “but it will likely be 3-4 years before they are up and running.” While not a quick fix to chip supply concerns, it may provide more long-term supply-chain security in the semiconductor market.

Nevertheless, Haworth points to the auto industry as an example of the economy starting to bounce back from supply chain shortages. “Before the COVID-19 pandemic, U.S. auto sales reached 17 million per year. It dropped to 13 million in light of supply shortages, but is now up to a pace of 15 million per year.”

Labor shortages

Haworth says it’s difficult to know if the continued shortfall in car sales from the pre-pandemic peak is due to elevated prices, the lack of desirable vehicles or a supply constraint in labor. “While supplies and transportation hubs seem to be keeping pace these days, labor shortages may be the biggest issue affecting the supply chain,” says Haworth.

In today’s environment, unemployment lingers near historic lows and job openings remain high. “The major challenge for many employers is whether they can attract and retain sufficient quality labor to meet their production demands,” says Hainlin.

Where we go from here

Easing supply chain issues appeared to contribute to rising inflation’s slowing pace. “We’re seeing those supply-chain problems significantly mitigate, inventories are being built, shipping costs have come down,” said U.S. Treasury secretary Janet Yellen. “And so that part of inflation is no longer really contributing very significantly.”⁵

The Federal Reserve, meanwhile, remains focused on bringing inflation down to its target range of 2%. The Fed raised the short-term target federal funds rate by 5.00% in a little less than a year, beginning in March 2022. After pausing its rate-hiking regimen in June 2023, the Fed left the door open to additional rate hikes in the coming months. The Fed continues to make borrowing more expensive to help lower demand, which would also help ease supply pressures and slow inflation.

Market participants are closely monitoring the Fed and other central banks around the world to see if they can tame inflation without triggering a serious recession. In the U.S., the confluence of changing interest rates and higher inflation– offset to some degree by persistent consumer demand and a strong jobs market – are all key factors influencing economic growth that investors will be monitoring in the months ahead to determine the impact on corporate profits and stock prices.

Talk with your wealth planning professional to determine how economic developments such as inflation trends may impact your own investment strategy and your long-term financial goals.