Everything happening in our economy today hinges on inflation. If inflation continues to fall quickly, robustly, and smoothly, we can expect the U.S. economy to rebound well. Consider it a softish lan...
Capital Markets
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5 min read
The “Global Supply Chain” has a lot in common with football’s offensive lineman. If you don’t hear an offensive lineman’s name or number come up during a game, that usually means he is doing a good job, or at least he’s not doing a bad job. When you hear his name more than once, it usually means he is having a bad day and losing the game for his team. The same can be said for the global supply chain. It is fascinating to learn where certain vital things come from and what those vital things actually mean to our everyday lives. For instance, when we are told that much of the world’s palm oil comes from Malaysia, and due to that country’s terrible COVID surge, we also find out that a shortage of palm oil leads to both shortages and higher prices of lipstick, soap, and detergent. Who knew? I know I did not, nor did I really care. Now, however, I do.
What we are witnessing now is relatively unprecedented in the Post-War world. The combination of the pandemic, decades of global supply chain building, and revolutionary “Just in Time Inventory” strategies have left nearly every strategic business wanting for things that they absolutely need to function normally. Global central bankers have told us repeatedly that the current spike in inflation is “transitory”. At the Fed’s Jackson Hole summit this August, Federal Reserve Chairman Powell laid out five points to support his (and all major central bankers’) theory on the nature of current inflation. From Reuters:
- IT'S NOT BROAD-BASED
- THE BIGGEST SURGES ARE ALREADY RECEDING
- NO THREAT FROM WAGES, SO FAR
- INFLATION EXPECTATIONS ANCHORED
- GLOBALLY, THE PRESSURE IS DOWNWARD
To be honest, a month ago, we would have agreed with at least four of these points. Things, however, have changed dramatically in the last few weeks. For example, on Friday, automaker GM stated that, while demand is strong, supply continues to be constrained by material shortages, most notably semiconductor chips. As a result, third-quarter new vehicle sales were down 33% from last year’s third quarter and 39% from third-quarter 2019. Moreover, GM stated that GM dealers have 128,757 vehicles in stock. Normally, GM dealer inventories are kept at about 800,000. That tremendous difference might have been heralded as a victory for “Just in Time” inventory management if we were in a sharp demand-driven recession.
Unfortunately, at present, this is not the case. Central banks, with the Fed leading the vanguard, have done a fantastic job stoking aggregate demand. The Fed has a great set of tools, forged in the battles of “The Great Recession” of 2007-2009, to deal with aggregate demand collapses. Moreover, for the current COVID pandemic crisis, the Fed was joined by the Federal Government’s massive fiscal stimulus and protection programs to boost demand. In our opinion, it would be disingenuous to criticize the Fed for the actions they have taken. Certainly, in the spring of 2020, it looked like demand would fall off a very steep cliff. Supply, on the other hand, really was not considered a problem because it was not immediate and frankly, we knew very little about COVID other than every new discovery made the outlook worse.
The act of stoking demand in the face of sharply declining supply has now put us in a pickle really not seen since the stagflation of the 1970s, high inflation coupled with a sharp recession. The last three times the world was subject to a massive supply shock were in the 1970s with OPEC’s 1973 embargo, the 1979-1980 Iranian Revolution, and Iran’s war with Iraq. In the 1973 OPEC Embargo Energy Crisis, for the first time in the Post-War global economy, plentiful and cheap supplies of the most vital input, oil suddenly in a flash was not cheap or plentiful anymore as OPEC launched an embargo to the West. The result was a drop in aggregate demand, a squeezing of profit margins, and a painful recession in 1974. In this crisis, OPEC was limited to how long it could hold out not selling its only real asset to customers that made up most of the oil’s demand. They made their point, caused a lot of pain, and then went back to doing business.
Then, in 1979, the Iranian Revolution essentially shut off the oil supply from the world’s second-largest producer. Furthermore, when Sadaam Hussein attacked Iran in 1980, oil supplied by Iraq was also severely curtailed. Once again, with the supply of oil shocking the global economy, eventually, industrial output ground lower and aggregate demand fell sharply, and we fell into a deep recession. The difference between this crisis and the 1973 crisis was that it was not a voluntary decision to cut off the supply of oil. Rather, it was the result of a complete overthrow of the status quo in Iran and a brutal war between the two top oil-producing countries that included the destruction of each other’s production capabilities as well as threats to vital supply lines. Eventually, other producers stepped in to make up for the loss of Iranian and Iraqi supply and, by the late 1980s, the world was awash in oil.
The supply shocks of the 1970s showed firstly that a sudden shortage of a key industrial resource could cause severe shortages in a multitude of products and services and simultaneously create corrosive inflation or stagflation. These shocks and subsequent bouts of stagflation proved impervious to monetary policy as well as fiscal policy. Essentially, the problems needed to work their way through the economy like a virus. Eventually, demand dropped with recession and supply eventually returned to normal while all the best government and central banks could do was to try and ease the pain of the virus symptoms and wait until equilibrium returned.
The problems we face with the global pandemic simply dwarfs the 1970’s supply shocks. With many parts of the world currently experiencing energy supply shortages, one could say that this is an energy crisis plus a global pandemic. The solutions back in the 1970s were relatively simple. Lift the embargo (1973) or make up the production lost to revolution and war (1979-1980). There are no simple answers in 2021. The only real answer may be to stamp out the virus globally, something that may take another year or possibly two years. Perhaps the best thing the Fed can do is to do nothing. Don’t raise policy rates, don’t taper, and don’t increase QE. It feels like we are on our way to a supply shock recession. Think of what we noted earlier regarding GM. Material shortages are drastically reducing sales revenue and have begun squeezing the margins on the sales they can actually achieve. The reaction has been to idle plants and the next step could be laying off workers. We know that the days of “how GM goes so goes the country” are over but still, this is what happened in the 1970s to the world economy and it is hard to not see it happening this time around either.
Perhaps letting nature take its course is the best answer, at least from a monetary policy standpoint. A recession and a sizable correction in financial assets could be needed to dampen demand while we wait for the global supply chain to come back online. That certainly isn’t going to win any popularity contests but maybe it’s the best option for a problem that doesn’t seem to have any real solution other than to beat COVID globally. The quicker we do it will dictate when we can start to really feel good again.
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