Inflation, Interest Rates and Supply chain Disruptions

Inflation has remained a predominant concern among market observers, macroeconomic experts, and supply chain planners, especially in light of the recent noteworthy sticky inflation prints from last week and February's release.

While doing some research this past weekend, I stumbled upon a valuable article from the Cleveland Fed last year that delves into the impacts of supply chain disruptions on inflation, particularly since the onset of the pandemic in early 2021, which significantly disrupted global trade. Let's break down the key points and insights:

Context: The article sets the stage by noting that inflation has consistently exceeded the Federal Reserve’s 2 percent target since early 2021. It identifies various potential contributors to this elevated inflation, including a resurgence in aggregate demand, tight labor markets, energy supply disruptions, and supply chain disruptions.

Supply Chain Disruptions: The article underscores how supply chain disruptions have increasingly captured attention in recent years due to events such as natural disasters, trade wars, and geopolitical crises. It emphasizes that disruptions were further exacerbated by COVID-19-related shutdowns, resulting in order backlogs and transportation bottlenecks. While some of these challenges are now in the rearview mirror, geopolitical constraints unfortunately continue to escalate.

Methodology: The authors utilize a vector autoregression (VAR) model to analyze inflation drivers, considering variables including important monthly indicators of economic activity, supply chain conditions, consumer price inflation, monetary policy, and financial conditions (growth in non-farm payroll, supplier delivery times from the Institute of Supply Management (ISM), core PCE inflation, the 2-year Treasury bond yield, and the spread between Baa corporate bonds and 10-year Treasury yields).

Of course the Fed’s Financial Conditions Index (FCI) is subject to frequent redefinition, but that’s a discussion for another day. The most notable missing elements in the above model, in our view, are small business loans, and consumer credit.

Impact Assessment: They evaluate the impacts of both aggregate demand and supply shocks on inflation and economic activity. The analysis suggests that supply shocks, including supply chain disruptions, have significantly contributed to driving inflation since early 2021. Historical data from January 2015 to December 2019 also indicates the importance of supply chain disruptions, albeit with some ambiguity in interpretation.

Decomposition of Shocks: The article decomposes unexpected inflation into contributions from demand, interest rate, financial, cost-push, and supply chain shocks. It concludes that supply chain disruptions were the most significant driver of inflation from January 2020 to December 2022, outweighing the contributions of other shocks.

Historical Analysis: Comparing the recent period to January 2015 to December 2019, the authors note that supply chain disruptions were also important drivers of inflation during that time, albeit with some uncertainty due to the challenge of interpreting supply chain shocks in historical data.

Conclusion: The article concludes by emphasizing the significant role of supply chain disruptions in driving inflation since early 2021. It underscores the importance of understanding and addressing these disruptions to mitigate inflationary pressures.

Currently, the global economy is grappling with a perfect storm of supply chain disruptions, trade constraints, de-globalization, and geopolitical turbulence, resulting in a complex interplay between inflation and demand. At this critical juncture, it is imperative for policymakers to carefully consider whether hiking interest rates will effectively combat structural inflation, which is clearly supply-dominated rather than demand-dominated.

One could potentially dampen demand by raising rates, tightening financial conditions, restricting credit, and inducing more layoffs and higher unemployment rates, yet consumer prices are unlikely to drop significantly, and inflation may persist stubbornly. This represents a scenario of maximum misery for most Americans and should be avoided at all costs.

However, DeepVu is not here to advise policy makers, we're here to advise supply chain executives and hands on planners. So what are they supposed to do in this fragile macro environment and increasingly constrained global trade?

Rank the Causes of Supply Chain Shocks

1. Geopolitical Tensions: The Russia-Ukraine conflict, and trade wars have significantly impacted global supply chains.
2. Natural Disasters: Frequent occurrences of natural disasters, such as hurricanes, wildfires, floods, and droughts (such as Mississippi river now and Taiwan last year) have disrupted production and logistics.
3. Technological Disruptions: Cyberattacks, data breaches, and technological failures have compromised supply chain resilience.

Map the Effects on Consumer Goods and Simulate them in the Digital Twin

1. Price Inflation: Supply chain shocks have led to higher production and transportation costs, resulting in a higher BoM cost which consequently leads to higher prices for finished consumer goods.
2. Product Shortages: Disruptions in supply chains have caused stockouts, leading to reduced availability of essential products.
3. Quality Compromises: In an effort to maintain production levels, companies may compromise on product quality, potentially damaging brand reputation. Therefore if you buy manufactured components you may have to work with lower yield parts.

Always On Mitigating Strategies via AI Decisioning Assistants

1. Diversification: Companies can reduce dependence on single suppliers or regions by diversifying their supply chains and building better resilience and tolerance across their multi-echelon network! In other words continuously assess your network for vulnerabilities to shocks and adopt a roadmap for continuous resilience.
2. Investment in Effective Technology: Implementing advanced technologies, such as AI Decisioning Agents and vertical specific Knowledge Graphs are critical to boosting supply chain resilience and agility. Planning Agents learn from feedback and are capable of reacting smartly to the shocks they've seen in their simulation environment. They recommend actions to optimize your KPI as opposed to static always fading in accuracy forecasting models.

Conclusions

Supply chain shocks are here to stay and have become the new norm, and their impact on inflation and demand is complex and multifaceted. By understanding the causes and effects of these disruptions, and mapping them accurately in the digital twins, businesses executives and planners can work together to develop strategies that mitigate the negative consequences and ensure a more resilient and adaptable supply chain ecosystem.

Let me know if you have any questions about your specific resilience challenge or shock that hasn't occurred yet you'd like to simulate and mitigate, or if there's anything else we can advise you on. Thanks for reading!

You can DM me here, or comment or reach out on #DeepVu's page.

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