Inflation and Supply Chains

Growing Concerns in a Disturbed Global Context

27 June 2023


The current global economic crisis is characterized by numerous uncertainties, particularly evident in the form of violent inflationary waves that have affected countries worldwide. Previously, major economies had been enjoying near-zero interest rates for extended periods, but they have now implemented monetary tightening measures. Consequently, their base interest rates have followed an upward trend in an effort to curb rampant inflation. In the United States, inflation reached a level unprecedented in four decades, with an annual inflation rate of 9.06% recorded at the end of June 2022. However, following multiple interest rate hikes over the past 15 months, the inflation rate has now averaged 4% as of May 2023. This figure still exceeds the target inflation rate of 2% by a significant margin. It is worth noting that the euro area, the European Union, and the United Kingdom also experienced new peaks in inflation rates during this period, marking a surge unseen in Europe since World War II.

Triggers of Global Inflation

Inflation is typically triggered by factors associated with both the demand and supply sides of the economy. However, the current crisis is characterized by a combination of these factors. On the demand side, the prolonged closures witnessed by several countries in 2020 as a preventive measure against the COVID-19 pandemic resulted in suppressed demand for various products, particularly capital and intermediate goods, as well as production inputs. In contrast, there was an increase in demand for consumer and technical products through e-shopping platforms and other digital purchasing tools.

Furthermore, the stimulus packages implemented by countries to support their citizens during the crisis acted as an additional source of inflationary pressure. These packages bolstered the demand for goods and services, particularly as the recovery from the crisis began in mid-2021.

The swift rebound in demand, coupled with the stimulus packages that injected purchasing power into the economy, contrasted with the slower recovery in supply. This disparity was influenced by various technical, logistical, and financing factors that will be discussed later. As a consequence, a demand-supply gap emerged and continued to widen, leading to a direct increase in inflation rates.

Additionally, inflation was exacerbated by the pass-through effect. This effect occurred when energy prices surged, impacting all industries and economic activities. The resulting high costs of production, transportation, shipping, and storage were passed on to consumers whenever the demand elasticity allowed. This distribution of costs helped prevent producers from bearing the full burden of the losses alone.

The severity of that crisis was compounded by the outbreak of the Russo-Ukrainian war, one year before economic activities restored some of their pre-pandemic levels. That war, its inflationary effects were based directly on the disruption of supply chains, for the following main reasons:

  • Restrictions on navigation and trade in the Black Sea.
  • Restriction on air transport between Asia and the United States, as a result of the ban on flying over Russia, which is directly reflected in the length of flight paths and the high cost of transportation.

In addition to the factors mentioned earlier, there are indirect reasons contributing to the current disruptions in international supply chains. These disruptions stem from the impact on commodity supplies, including agricultural products, energy products, and industrial raw materials. The exports of these commodities have been affected by the conflict between two countries that control a significant portion of these commodity groups.

Nearly three years since the onset of the Covid-19 pandemic, the escalating Russian-Ukrainian confrontation serves as a reminder of the importance of national and regional independence, with a growing emphasis on de-globalization. This emphasizes the need for countries to ensure self-sufficiency in meeting their basic needs due to the disruption and restriction of global trade. As a result, there have been capital inflows and a significant surge in logistical costs, particularly in transportation, which has reached unprecedented levels not seen in decades.

Disruption of Supply Chains

In the last two decades, global trade logistics schemes were established based on relatively affordable transportation, with price variations depending on the type of goods being transported. The concept of "energy transition" hinted at efforts that could further reduce transportation costs. However, the transport budgets for 2022 differed significantly from those of 2019 due to various factors.

The COVID-19 pandemic caused a notable increase in freight transportation prices. Subsequently, the ongoing war in Ukraine exacerbated the crisis, intensifying and prolonging its impact over time. The inflationary effect on transport prices first became evident in container sea freight and air freight, and it is now extending to European road transport costs, gaining momentum in the process.

Inflated Production Costs

The increase in transportation costs in 2021 and 2022 can primarily be attributed to the recovery in demand triggered by stimulus packages and the release of pent-up demand, as mentioned earlier. This imbalance between available supply and increased demand granted carriers greater negotiating power, resulting in higher freight rates. Additionally, inflationary pressures from various sources, particularly higher energy and commodity prices, due to the rapid rebound of the economy (V-shaped recovery), further contributed to the rise in freight rates.

There were hopes of gradually achieving a balance between supply and demand. However, the global economy was hit by another shock due to the war in Ukraine, disrupting this expected equilibrium. The shocks to production costs were evident in the prices of energy products, industrial and agricultural inputs, and their impact on incomes. The following points provide further explanation for these effects.

A- High energy prices:

Beginning in 2021, oil prices experienced fluctuations and became more volatile following the outbreak of the war in Ukraine. Despite some ups and downs, prices have generally been stabilizing around an average of $80 per barrel in 2023. However, the situation was concerning enough that on March 18 of the previous year, the International Energy Agency called for the publication of a contingency plan consisting of 10 measures aimed at reducing global oil demand by 2.7 million barrels per day. This plan aimed to mitigate the risk of severe shortages.

Similar to how the COVID-19 pandemic influenced the restructuring of industrial sectors in Europe and the United States, the war in Ukraine has heightened awareness of the importance of the "energy transition." In the short term, the United Nations Conference on Trade and Development (UNCTAD) expresses concerns about a potential setback in the energy transition. In a report, it stated that the significant increase in oil and gas prices could divert investment back to extractive industries and fossil fuel-based energy generation. This threatens the positive trends observed in the past five to ten years towards renewable energy sources.

B- High prices of industrial and agricultural food commodities:

Food prices saw a rise of 1.9%, while beverage prices and raw materials prices increased by 5.5% and 1.0%, respectively. Fertilizer prices, on the other hand, eased down by 1.3%. Metal prices witnessed a slight decline of just under 1%, influenced by decreases in iron ore (-8.6%) and zinc (-6.7%) prices, which were partly offset by increases in tin (+7.5%) and nickel (+2.6%) prices. Precious metals experienced a gain of nearly 6%.

C - the potential impact of income and its relationship to production costs:

The current price levels, including the increases in energy prices and other commodity prices, contribute to the growing demand for higher wages. The transport and logistics sector, being labor-intensive, was already facing challenges in terms of hiring even before the crises unfolded. With the upward pressure on wages, the sector will experience further impact on total costs in 2023.

Ramifications of the War in Ukraine

The new global crisis triggered by the war in Ukraine is occurring during a period when the health situation worldwide remains uncertain. Supply chains have not fully recovered to pre-pandemic levels of operational stability. Although the congestion of container ships in ports has reduced, it has not completely disappeared, and it is premature to declare a post-pandemic context.

China's "Zero Covid" strategy, which was eventually relaxed, resulted in additional restrictions on trade and shipping movements centered around China. For instance, Foxconn, a major supplier for Apple, announced in mid-March 2022 that it would temporarily suspend operations in its technology center located in the Chinese city of Shenzhen due to health restrictions imposed on various activities. 

The semiconductor industry has indeed experienced disruptions due to the COVID-19 pandemic. Despite facing high demand prior to the pandemic, several semiconductor factories, spread across Asia, were compelled to shut down as employees had to adhere to closure regulations. These periods of downtime resulted in a backlog of demand, increased costs of restarting operations, and the need to create a specialized production environment for these products. These factors contributed to higher prices for distributors and consumers. Consequently, many consumer goods relying on semiconductors as crucial components, such as mobile phones, cars, and medical devices, have been affected in terms of production, supply, and consumer prices.

To address this supply-demand imbalance, the American company "Intel" announced a significant investment plan of 80 billion euros in the European Union over the next decade. As part of this plan, Intel intends to establish a semiconductor factory in Germany. Such initiatives aim to increase semiconductor production capacity and enhance the global supply chain, thereby mitigating the impact on consumer goods and prices.

Indeed, different industries are impacted to varying degrees by inflationary pressures. Industries that rely on long and complex supply chains tend to experience a more pronounced effect on prices. This is because each step along the supply chain amplifies the inflationary impact, considering the costs associated with raw inputs and intermediate goods.

To illustrate this point, let's consider the example of processed meat. The production of processed meat involves various stages within the supply chain. It starts with the production of animal feed, which requires inputs such as fuel and electricity for agriculture. Each step in the process of harvesting, converting, storing, and delivering animal feed to the farm incurs costs that contribute to the overall production expenses. Subsequently, animals are transported to the slaughterhouse, and the processed meat is then distributed to wholesalers, retailers, and finally, consumers.

Worries and Positive Signals Ahead

UNCTAD's concern regarding the impact of the war in Ukraine on agrarian commodities is justified, as some countries heavily rely on food imports from both Russia and Ukraine. The pressure on commodity prices can also be attributed, in part, to significant changes in consumption patterns since the start of the pandemic. These changes occurred due to various factors, including the necessity to adapt to new living and work arrangements, as well as the mandatory bans, closures, and movement restrictions imposed. Additionally, many sectors were forced to halt their activities.

As a result, there has been a rapid shift in demand from services activities, such as food, accommodation, and entertainment, towards commodity activities, such as food, beverages, and consumer goods. This sudden surge in demand has affected the production and availability of these commodities, leading to price fluctuations.

Regarding monetary policy, the US Federal Reserve recently paused its rate hike cycle during its latest review. Although interest rates remain relatively high, ranging from 5.00% to 5.25%, the pause indicates a cooling down of tightening policies due to improvements in inflation and employment rates in the US. However, the Fed's announcement did not confirm the termination of monetary tightening until the end of the year. As a result, people will closely monitor inflation rates to gauge whether they will approach the target rate of 2%. It may also prompt discussions on whether a reassessment of the inflation target is necessary.

It's important to note that further increases in interest rates raise the cost of capital, which can exacerbate supply shocks and disrupt supply chains, ultimately leading to higher inflation rates driven by supply factors rather than demand. Finding a balance between managing inflation and ensuring smooth supply chains is crucial.