Reminder: Supply issues are still driving inflation

It's "highly uncertain" when they will resolve, a Fed analysis states.

blue and red cargo ship on dock during daytime

Supply issues are still a major contributor to inflation. (Photo by Dominik Lückmann on Unsplash)

At a time of economic swings, everyone watches for signs of how the causes are playing out on the ground, and when things might get better. Inevitably, this leads back to a close monitoring of the two forces shaping the economy: supply and demand.

That has been true in the shifts of the last two years.

In 2021, supply was in focus, as bottlenecks in the supply chain made goods tougher to get. Delayed shipments and out-of-stock notifications were the signs of this shock.

As inflation increased in the spring of 2022, demand took center stage. Consumer behavior is being closely watched for signs that spending habits are changing as prices go up. In fact, retailers are now dealing with too much inventory, which could perhaps be taken as a sign that demand has overtaken supply as the focal point. The issues are not so much making and acquiring goods as moving them.

The two appear to swing back and forth.

Determining what caused the period of 40-year-high inflation that the economy faces right now could help find a way out, so the question becomes, was it supply or demand?

It turns out that the answer is both, and supply played a larger role. That's according to a recently-published Economic Letter from Federal Reserve Bank of San Francisco Senior VP of Economic Research Adam Hale Shapiro.

The analysis shows that supply factors account for about half of the rise of current inflation levels, while demand accounts for about one-third of the run-up. The rest is attributable to “ambiguous factors,” Shapiro writes.

This balance is even more apparent when it comes to so-called “core inflation,” which factors out food and energy to focus on consumer goods. Shapiro found that supply and demand each contributed to about half of rising inflation across these categories.

A chart shows supply and demand contributions to inflation.

(Graph via Federal Reserve Bank of San Francisco)

For those watching demand, the letter offers a reminder: supply issues remain an overriding concern in this economy. They’ve been with us since at least April 2021 and haven’t slowed since. Labor shortages, pandemic-related supply chain disruptions around the world that are only starting to heal and the war in Ukraine are all feeding inflation from this side.

As a result, supply-related issues are likely to play a major role in determining when inflation will start to ease. It also makes that timeline tough to predict right now.

“The large impact of supply factors implies that inflationary pressures will not completely subside until labor shortages, production constraints, and shipping delays are resolved,” Shapiro writes. “Although supply disruptions are widely expected to ease this year, this outcome is highly uncertain.”

To be sure, demand still has a big role and should be watched closely. Shapiro points out that categories like furniture, clothing, toys and cookware showed “extraordinarily frequent” demand-driven price changes during the last two years. Inventory and other demand-related issues are still a big concern to retailers and those selling consumer goods, especially as a swing back towards spending on services and experiences reshapes consumer behavior.

It's just that the supply side is an important predictor of where we’re heading. It is of particular concern for policymakers at the Federal Reserve. Shapiro points to recent remarks from Fed Chair Jerome Powell during an interview with NPR’s Marketplace:

“What [the Fed] can control is demand, we can’t really affect supply with our policies…so the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control,” Powell said.

In other words, the 30-year-high interest rate hikes that the Fed is implementing are designed to cool demand. But its available tools may not be addressing the determinant of whether the economy ends up in a recession.

The Fed will continue to monitor supply and demand together, and share results at here.

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