The past two years have been tough on supply chains — a global pandemic and lockdowns, bottlenecks and disruptions that we were still working our way through, escalating commodity, labor and transportation costs. Now the war in Ukraine and the continuing impact of China’s “dynamic” zero-COVID policy on upstream manufacturing are just making everything worse. With inflation at its highest in four decades, the Federal Reserve recently raised interest rates. Can continuing pressure on supply chains lead to a recession? The answer is complicated, as there are some lengthy cause-and-effect chains in this puzzle.
A simple view of inflation is that it can be caused by “demand-pull,” an increase in the demand for goods and services caused by private and government spending, “cost-push,” a drop in aggregate supply that can arise from bottlenecks or disruptions in supply chains, “inflationary expectations,” or some combination of all of these. A shortage of supply relative to demand should cause prices to rise, and an excess of supply for anything over demand should cause prices to fall. In many respects, we have been living through the first two of these, and we are getting dangerously close to the third. At the beginning of the pandemic, the government poured money into the economy through the 2020 Cares Act and the American Rescue Plan Act of 2021, and Americans went on a buying binge that fueled congestion on the main import trade lanes. That’s the demand-pull side.
Meanwhile, a string of COVID-induced shutdowns around the world, labor shortages, factory fires, last year’s winter weather in Texas and general difficulties manufacturers have had in responding to rapidly changing demand patterns led to bottlenecks in ports, intermodal rail, trucking, and warehouses among other places. Supply chain woes have made the daily news for a year and a half now, as shortages have spread from computer chips for cars and gaming consoles to just about everything, and the war in Ukraine is adding to shortages and dramatic price increases in key agricultural and industrial commodities. That’s the cost-push side.
Like other central banks, part of the mission given to the Fed by Congress is to keep prices stable, and it likes to see an inflation rate of about 2 percent a year. By raising the federal funds rate, the rate that banks use to make overnight loans to each other, it makes it more expensive for consumers and businesses have to pay more to borrow money. This usually dampens demand. As those car payments, the mortgage interest rate on a new home, or the costs to build a new factory or hire more workers go up, consumers and businesses slow down their spending. In principle, weakened demand should reduce the pressure on prices.
A year ago, Harvard economist Larry Summers cautioned that too much stimulus spending risked overheating the economy and driving inflation, and his view has largely been vindicated. If you talk to people in the logistics industry, many are saying the bottlenecks won’t ease until the American consumer buying binge slows down. Summers points out that supply is what it is, and monetary policy can’t change it.
The Fed has a tough problem. If it raises the target rate too fast or too much, it could dry up demand quickly and put the country into a recession. If it raises rates too slowly or by too little, inflationary pressures could continue unabated for much longer than it wants. Right now, a lot of people are debating whether the Fed waited too long to raise rates, or whether it should be more aggressive and increase the rate in larger steps. The big challenge is the time lag before any impact is felt. Change the Fed funds rate today, and it might be 12 to 18 months before the effects on demand work their way through the economy.
Meanwhile, prices of commodities like oil, natural gas, wheat and corn fluctuate on very short cycles. Russia and Ukraine supplied 29 percent of global wheat exports last year. Russia is one of the world’s largest exporters of fertilizers and a leading exporter of oil and gas. Gro Intelligence reported that wheat prices were up as much as 46 percent just from the start of the conflict on Feb. 24, 70 percent year over year. Corn is up 35 percent and soybean oil up 40 percent. Significantly, wheat future prices are steeply inverted. That means contracts for delivery soon are priced much higher than contracts for delivery that are out in time.
If you had an engineering background, you would recognize that the Fed has a control systems problem. It’s trying to manage through short cycle fluctuations when its tools are only really useful for long cycle fluctuations. So, the Fed has to thread a needle on raising interest rates — not too fast, not too slow, get it just right, please. If you get it wrong you might overshoot and cause a recession, or undershoot and have the politicians at your throat. Actually, the politicians will likely be at your throat unless you engineer a perfect soft landing. If you were a control systems engineer, you would quickly see this as a really difficult problem.
Let’s remember that the Fed’s monetary decisions are intended to be long-term. One could argue one reason everyone was talking about “transient” inflation and price spikes last year was a recognition of the dichotomy between short-term effects and long-term remedies. Plus, there was the hope that the short-term spikes would subside. But what we are seeing now is longer term impacts — cutting Russia off from the global trading system, the compounding effects of parts shortages tying production into knots. Even if overall demand cools, it’s still going to take a while to untangle this mess. I’m glad I don’t have Fed Chairman Jerome Powell’s job.
Willy C. Shih is the Robert and Jane Cizik professor of management practice at the Harvard Business School. His research focuses on global manufacturing and supply chains. Follow him on Twitter: @WillyShih_atHBS