The last time inflation was this wickedly pernicious was at the dawn of MTV. You may know that the classical definition of inflation is when too many dollars are chasing too few goods. Like the 1980s, there is an abundance of cash in the economy today, and there are areas where demand seems outsized – we are looking at you, housing market. However, inflation-adjusted spending¹ is merely back on pre-pandemic trend lines. The problem does not lie, yet, on consumers hoarding goods. It is supply issue.

That supply problem is a CURSE (China, Ukraine-Russia, and Strong Employment.) In fact, the Global Supply Chain Pressure Index² is extremely elevated and not showing signs of an imminent easing.

China – China is a manufacturing powerhouse, accounting for almost 30% of total global aggregate production, according to the World Bank. The country’s industrial output is 1.7 times that of the United States, its closest competitor. When the country entered into its Zero COVID lockdowns, upwards of $10 billion per day of goods were not produced. The impact of $10 billion dollars of lost output, in normal times, may be a rounding error of global GDP; however, a significant portion of Chinese industrial output is in electronic component parts rather than finished goods. The lack of these “parts” has a ripple effect around the world on final goods output from smartphones, to cars, to washing machines and beyond.

Ukraine-Russia – Russia is most certainly a key exporter of oil and natural gas, but upwards of 25% of the world’s fertilizers, wheat and barley, not to speak of corn and iron, have effectively been cut off from global markets due to Russia’s invasion of Ukraine. Again, like the Chinese component issues, taking this production offline inflicts widespread economic damage both directly and indirectly and requires the supply chain to change in less efficient ways to deliver goods where they are needed.
 
Strong Employment – Theoretically, the shortages caused by foreign shocks could be solved by the economic might of the United States; however, we need time and workers to do so. Given the low unemployment in the country, we do not have significant underutilized resources that can be brought online quickly. There are not enough idle workers that could be employed to fill the gaps created overseas, nor can US manufacturing be expanded overnight. The current manufacturing capacity utilization readings show that we are at the sustainable maximum output given our current stock of factories. Strong employment is usually a desirable economic trait, but not a limitless one.

Without fiscal alternatives (not that they do not exist, just that they are unlikely), that leaves the Federal Reserve to fight rapidly increasing costs. The Fed is wonderful at providing and removing liquidity from the economy. They can pluck the chords of consumer demand like Yo-Yo Ma playing the cello. Supply issues, however, are the Fed’s kryptonite. Monetary policy cannot pump more oil, grow more grain, or build an iPhone. They can raise 50 basis points, they can raise 1%. The only effect that they can have on inflation in an environment like this is to squash demand, which is not oversized, to fit the supply that we have and likely create a recession. Land wars in Asia rarely come without a lot of misery.

The potential good news is that the financial markets are forward looking. They do not wait for economic developments to occur; they often move in anticipation of such events. We expect heightened volatility to continue for some time given the multitude of issues happening in the world, but we also remind investors that the time to plan for times like these are before they happen rather than in the midst of them.

¹ Real Personal Consumption Expenditures as tracked by the U.S. Bureau of Economic Analysis, https://fred.stlouisfed.org/series/PCEC96
² Federal Reserve Bank of New York, Global Supply Chain Pressure Index, https://www.newyorkfed.org/research/policy/gscpi#/interactive

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