Supply Chain Disruptions, Inflation, and the Fed

Used cars became a hot commodity during the pandemic, with their prices increasing by roughly 50 percent between January 2020 and December 2021. The spike in used car prices was a prominent example of how global supply chain disruptions have contributed to U.S. inflation. It also highlighted the complexity of global supply and demand relationships.

In the early stages of the COVID-19 pandemic, many U.S. and European auto manufacturers shut down production to help stop the disease's spread. Semiconductor producers, concentrated in Asia, responded by shifting production toward chips for electronic devices such as computers and games. As the pandemic progressed, demand increased in these other markets as homebound consumers shifted their spending away from services such as restaurant meals and travel and toward consumer durables.

Later in 2020, when U.S. auto manufacturers resumed production, they faced chip supply shortages. The shortages not only reflected pandemic-related production shutdowns in Asia, they also reflected a reluctance on the part of chip manufacturers to shift production back to chips used in auto production and away from the relatively lucrative market for chips used in electronic devices.

The diminished supply of new cars in the U.S. market provided support for higher used car prices. (See chart below.) Since used cars comprise roughly 4 percent of the basket that makes up the consumer price index (CPI), the 50 percent cumulative price increase for the category increased the overall CPI by a cumulative 2 percentage points. According to an analysis by Richmond Fed economist Alex Wolman, the increase in motor vehicle prices ranked as one of the "main culprits" of the U.S. inflationary increase through November 2021.

The used car example illustrates the limited ability of monetary policy to control inflation's short-run trajectory. "It's true that inflation is a monetary phenomenon, in the sense that monetary policy has the ability to control inflation over the medium to long run," says Wolman. "However, even when monetary policy is being successful at controlling inflation, unusual shocks to supply and demand for particular goods and services move inflation around from month to month."

The U.S. economy has indeed faced a string of unusual supply and demand shocks since the pandemic's onset — most of which have tended to boost inflation. But this fact does not necessarily let the Fed off the hook.

A Mix of Supply and Demand Shocks

Since the onset of the pandemic, the U.S. economy has been hit by a series of supply and demand shocks. The first of these, of course, was the pandemic itself. Several early analyses of the pandemic characterized it as a combined supply-demand shock. For example, an NBER working paper in February by Martin Eichenbaum of Northwestern University, Sergio Rebelo of Northwestern University's Kellogg School of Management, and Mathias Trabandt of Goethe University Frankfurt presented a model of epidemics in which COVID-19 "acts like a negative shock to the demand for consumption and the supply of labor."

The view of the pandemic as a combination of negative supply and demand shocks found support in the data. For instance, a 2020 paper by Geert Bekaert of Columbia University, Eric Engstrom of the Fed Board of Governors, and Andrey Ermolov of Fordham University employed statistical methods to "extract aggregate demand and supply shocks for the US economy" during the early stages of the pandemic. The paper estimated that negative aggregate supply and demand shocks both contributed substantially to the initial output decline in 2020.

During the initial stages of the pandemic, there was much concern among economists and policymakers that the pandemic's initial negative effect on aggregate demand could be exacerbated by job destruction and firm closures. This concern was reflected in an American Economic Review article by Veronica Guerrieri of the University of Chicago's Booth School of Business, Guido Lorenzoni of Northwestern University, Ludwig Straub of Harvard University, and Iván Werning of Massachusetts Institute of Technology, which presented "a theory of Keynesian supply shocks: supply shocks that trigger changes in aggregate demand larger than the shocks themselves." Their preferred policy responses included many of the measures implemented by U.S. policymakers, such as emergency loans, enhanced social insurance payments, and accommodative monetary policy.

It did not take long for these measures to show results. One of their initial effects was to boost the U.S. personal savings rate. Bank accounts grew rapidly during 2020 as people received stimulus payments from the Internal Revenue Service and enhanced unemployment insurance checks — some received more from these benefits than they had been earning from their former jobs — while drastically reducing their spending on dining, entertainment, and travel. Flush with cash, many consumers quickly started to buy consumer durables.

"There was a huge surge in consumer goods demand, because households were simply unable to spend their cash on going out for a meal or going to the cinema or going on holiday," says Christopher Williamson, chief business economist at IHS Markit, a provider of data and research affiliated with S&P Global. "So, a whole lot of us spent a lot of time ordering new computers, furniture, and bicycles."

In retrospect, there is a broad consensus among economists and policymakers that the combination of increased fiscal spending and an aggressively accommodative monetary policy ultimately overshot the mark by providing excessive economic stimulus. To the extent that they did, the policies arguably constituted a second major shock to the U.S. economy. The Russian invasion of Ukraine in February of this year imposed a third major shock by restricting global oil and grain supplies, causing spikes in the two commodities' prices, which had been already increasing since mid-2020. The combination of the three shocks — the pandemic, the expansionary policy overshoot, and war — left analysts with a hard-to-identify stew in which pandemic-related foreign plant closures, heightened consumer durables demand, and increased global commodity prices have put tremendous strains on global supply networks.

Supply Chain Disruptions

There is no precedent in recent history for the supply chain disruptions that currently afflict the global economy. The scope of the problem is seen, among other places, in the recent behavior of the JPMorgan Global Purchasing Managers Indices (PMI) delivery time index, which provides a measure of delivery delays around the globe. Ordinarily, the delivery index tends to closely track the JPMorgan PMI new orders index. For example, when the new orders index declined during the 2008-2009 recession, the delivery index declined as well; and when the new orders index subsequently recovered, the delivery index followed suit. This positive correlation is just what one would expect for economic cycles that are driven primarily by fluctuations in aggregate demand: Weak demand means shorter waiting times; strong demand means longer waiting times. (See chart below.)

In contrast, the two indexes moved in dramatically divergent directions at the onset of the pandemic. The new orders index plunged, signaling a collapse in aggregate demand, but the delivery time index spiked upward. This negative correlation is just what one would expect for an economic cycle driven by a combination of negative supply and demand shocks.

Supply disruptions (as reflected in the delivery time index) became even more pronounced as aggregate demand (as reflected in the new orders index) recovered. The new orders index peaked in mid-2021, and subsequently declined. Nevertheless, the delivery time index has remained near its historical peak, signaling continued supply problems.

Global companies reported reduced production due to staff shortages that peaked during each of the pandemic's various waves, according to data from S&P Global. Each wave of staff shortages gave rise to a follow-on wave of materials shortages.

Transportation snarls exacerbated the problems caused by plant closures, further disrupting global supply chains. "There were a lot of port closures — notably in China," says Williamson. "With restrictions heavily in place, the ports just couldn't function as efficiently as they could before. And it's not just ships going into ports, but trucks bringing containers in and out of the ports. A lot of containers ended up in the wrong places. It produced unprecedented congestion."

By late 2021, shipping a container through U.S. ports took more than three times longer than it normally did. The congestion at Chinese ports only worsened recently due to COVID-19 lockdowns in Shanghai and other ports. Shipping costs have remained elevated, and port congestion has had numerous effects that may have been hard to predict. California farmers, for instance, have been having a difficult time finding container capacity to export tree nuts, produce, and dairy products.

Of all the supply problems that have arisen during the pandemic, semiconductor shortages have had some of the most widespread effects. In many cases, semiconductors account for only a small part of a product's total cost. Yet they often have no close substitutes, making them indispensable to the production process. Because of this, semiconductor shortages can have an outsized effect on final-product supply shortages and the inflationary pressures they create. Recent research by economists at the St. Louis Fed indicated that the problem extended far beyond the auto industry to a broad range of other U.S. manufacturing industries. Comparing 56 industries that use semiconductors as a direct input with 170 industries that do not, they found substantially higher price changes in the semiconductor-dependent industries during 2021.