The Return of Inflation: What Does It Mean for Supply Chains?

AH-OW! THE ACCOMPANYING chart presents a disturbing picture. After almost 10 years of low inflation, pricing is rising steadily, reaching a 6.8% rate in November. Supply chain participants must understand what is happening, what may happen, and what such developments mean for their business.

What is inflation? Let’s start by reviewing the concept of inflation. Most people understand it simply as price change. I spent $75 on a Christmas tree last year. It cost $85 this year. In order, however, to manage such changes, we need to know more about why a price went up.

Three types of inflation – each with different implications: Let’s use current truck prices to illustrate the different kinds of inflation. Freight rates are going up in part because the cost of operating a truck is rising. Fuel is more expensive; regulations add cost; there are also those troubles with liability insurance. This kind of inflation is important because it is relatively permanent. I estimate that such factors have added about $.10 per mile to freight rates over the last year. Of course, it’s worse in California. Trucking has had plenty of such cost inflations, things like the Hours of Service changes in 2004 and the ELD mandate in 2018.

Fortunately, productivity improvements also count as a cost change. So the industry can offset some of its cost changes—over time. Unfortunately, given the chaos in today’s market, such offsets are probably several years out. Consider also that the impending digital revolution has the potential to cut trucking costs in half. But in the meantime, that 10 cents per mile I quoted will stay with us.

Where does the driver shortage fit here? In most times, price change is determined by market conditions. When business is slow, prices fall. When, as now, demand overwhelms supply, prices go up. This is a big deal, especially in spot markets. At the bottom of the shutdown recession in 2020, spot prices were 23% below normal. Since then, under tremendous market pressure, they are way up, peaking at 55% above normal in the spring of 2021. Fortunately, such conditions are temporary.

Overall, truck prices are already down 13% from their peak (although van prices remain stubbornly near their peak). Here is the point about such market forces: They are the most likely factor to create market volatility—in either direction. They are also temporary. Truck spot prices should be back to normal by this time next year, probably sooner.

What do economists worry about? The money itself. The final issue is the one for which I am most concerned. It is why the business press is talking about inflation. Money is at its root an abstraction. We use it for convenience. Before money, people could only trade for what they wanted. “I’ll help you plow that field in exchange for a share of the crop.” Such barter is impossible in the complex world we share. So we convert all the products and services we consume into values of some form of currency, most commonly dollars, the abstract money managed by the Federal Reserve System (the Fed). In order to do that, the Fed periodically increases the money supply to balance the supply of currency to the growth of the economy. That process is a touchy thing. The Fed needs to strike just the right balance. Inject too much money, and inflation goes up—not enough, you get deflation.

Here’s where politics get in the game: Beginning in the 1930s, the Federal Government began trying to stimulate the economy, based in part on the teachings of John Maynard Keynes. They did it at first by borrowing money to fund investments and other injections of money into the economy. Predictably, such something-for-nothings proved politically popular. Eventually, the Federal Reserve joined the fray in using its money-creating power to provide further stimulus, despite the risk of inflation. In fact, it did result in inflation, just low inflation most years. Note that the bias for stimulus encouraged the Fed to aim for a 2% inflation rather than the neutral 0% inflation.

Where’s the catch? For most of the years since these policies started, the Fed has struck a workable balance, limiting inflation to a level objected to only by retirees. At 2% inflation, that $50,000 per year pension you expect at age 60 will be worth only $33,000 when you turn 80. Of course, borrowers like the Federal Government love inflation. The risk is that what happens in the market is a psychological thing determined by the opinions and emotions of its users.

If the Fed and its congressional partners inject too much stimulus into the economy, consumers begin to bid up the price of goods. What’s worse is when suppliers come to expect inflation and add those expectations to the market pressures on price. In the worst case, one gets into a vicious circle, as frequently happens in South American countries. The money loses its value, sometimes becoming worthless. That has never happened in the U.S., although the Fed lost control of inflation in the late 1960s and throughout the 1970s, leading to a peak inflation of 18% in 1982. Fortunately, the Fed Chairman, Paul Volker, with the tacit approval of President Reagan, reversed the existing stimulus policy creating a tough recession that abruptly killed inflationary expectations. That courageous stand kicked off 40 years of declining inflation. It didn’t hurt that the rise of low-cost, offshore competition injected a deflationary cost factor into the overall inflation calculations. That enabled the government to continue its policy of stimulation without increasing inflation. Put differently, without the stimulation, we would have had deflation for the last 20 years.

Is there too much stimulation now? By any measure, the Fed and Congress are providing unprecedented stimulation to the economy. It started with the trauma of the 2008-2009 Great Recession and has multiplied under our hysterical response to the pandemic. This policy is very troubling since the history lesson of the last paragraph reminds us that excessive stimulation can cause the Fed to lose control of inflation. Note there is a popular theory of economics called modern monetary theory that posits such dangers are no longer applicable. This third kind of inflation is called money supply inflation, as warned of by Milton Friedman and several generations of Austrian economists.

I write this piece because the unexpected inflation we are suffering in late 2021 suggests that the Fed is losing control of inflation just as it did in the 1970s. We have a flood of money chasing an economy with strong supply limitations. Moreover, there are anecdotal signs that the expectation mechanism is also at work. The apologists for the Fed’s policies have insisted that this burst of inflation is temporary. Be careful of that promise. That might be true if the Federal Reserve sometimes manages money supply to create deflation. Six percent inflation this year offset by -6% inflation next year. Of course, such balance would ignite a firestorm of political problems. The Federal Reserve has never caused deflation in our lifetimes.

So as a practical matter, the 6% inflation we currently have has taken a permanent bite out of any fixed income or assets you have. That’s ideal for borrowers, but not so good for lenders and retirees. Our policy makers are comfortable with that hit and say that inflation will fall back to that comfortable 2% as soon as this COVID-19 mess clears up. Unfortunately, they have been saying that since the first signs of this inflation appeared early last summer. On the contrary, inflation has gotten steadily worse. In summary, then, monetary supply inflation tends to be permanent and can be subject to damaging runups, that, in the worse cases, cause a monetary collapse, as we see from time to time in Argentina.

How does this Complicated Arithmetic Add Up in 2022?

One + one + one = three. We have three powerful cost inflations in play.

• One will reverse. That is the temporary reduced productivity due to supply chain failures. The other two look to have staying power.
• One is an upward trend in energy costs due to increased production costs and restrictive governmental policies.
• The other is the pandemic lesson about the need for more surge capacity in business. That increases costs for most years in exchange for avoiding the problems we have in times of crisis. Part of that process is reduced reliance on offshore sourcing.

The net for 2022 is a modest increase in cost inflation of 2% to 4%—until digital tools come to the rescue.

We are near the beginning of relief from market conditions’ inflations: We are approaching the inflection point in goods demand. As supply chains catch up, the remaining pent-up demand for things like autos will be satisfied. Then sales will return to normal. Moreover, we already see spending pivoting back to services, the normal focus of American consumer spending. This means goods demand will soon begin to fall back to normal. Since trucking demand is closely tied to goods spending, truck pricing will move back to normal. Albeit normal will be higher than before this crisis due to permanent cost increases. Still, it will be less than at the elevated levels we have now. The goods relief should be apparent by mid-year 2022; services by winter of 2023 (ski vacations excepted.) The net should offset most of the cost inflation by the year’s end. The Fed will be ready to declare victory.

Not so fast! We still have the difficult-to-quantify money supply inflation. Two factors argue strongly for the presence of this kind of inflation in 2022. First, the Congress has already passed two huge stimulatory bills. Although the 2022 number is only half the extraordinary numbers of 2020 and 2021, it is still 50% higher than pre-pandemic levels. Second, 2022 is an election year, one with control of Congress in play. No one wants to be blamed for reducing growth in an election year.

More stimulus is likely. That includes the supposedly non-partisan Federal Reserve. Yes, Chairman Powell has warned of discount rate hikes, from the current zero rate? Will he dare the 5% percent hike typical of such market conditions? I doubt it in this political environment. This analysis suggests that some amount of higher-than-recent inflation will persist in 2022, My guess is 4%-5%.

So what? There are four risks to monitor closely.

1. Pricing: Inflation puts stress on pricing policy and administration. Salespeople are under stress. The back office has to work harder. The finance people hate the lag between costs and pricing when inflation persists. Inflation is a major irritant that needs management. So it will be for supply chains in 2022.
2. Interest rates: Interest rates must account for inflation, especially in an era of uncertain inflation. The formula is: inflation + risk + return to the lender. So, if inflation is 4%, 2% above pre-pandemic levels, then interest rates need to be 2% plus the additional risk above what they were. Suppose you were borrowing at 4%. It will go to 6% or 7% in 2022, assuming 4% inflation. Capital expenditures will be under close watch in 2022.
3. Recession: Should inflation continue to rise—or stay at 6%—even our cautious Fed will be forced to react, as has every Fed since World War Two. Historically, that means significant interest rate hikes of 3% to 5%. Such rises have been associated with recession before. Our current economy’s dependence on historically low interest rates makes recession certain should interest rates rise as they have in the past. Consider just the example of the royally hot housing market. A conservative $300,000 loan at 3.8% interest requires roughly $1,400 in monthly payments. A 7% loan would increase that to $2,360. Put differently, a buyer who can just afford that house today could only afford half the house should inflation persist. Of course, that buyer’s income might increase, but not proportionately. One must keep in mind that the current economic boom is unusual and fragile. It is at risk from several plausible factors, the most likely being inflation. If my pessimism regarding inflation turns out to be justified, recession is a certain follow-on, late in the year or in 2023.
4. Catastrophe: Fortunately, history tells us that the Fed loses control of inflation gradually. The problem that Volker fixed in 1982 had been brewing for at least 15 years. This means that a dramatic government response, or a major collapse of the dollar, is highly unlikely in 2022, or any time over the next five years. Such an event is likely some time in the next two decades. It happened in 1982. However, its earlier appearance would require the presence of some external shock: a war, a global financial meltdown, a worse pandemic. Perhaps, the digital revolution will arrive soon enough to mitigate the longer-term risks of our nations’ borrowing obsession. Even if it does, the economy of the 2030s will be a volatile mix that none of us can understand from our current viewpoints.

A closing comment: I have learned from 45 years of forecasting that the next year always fits into one of two buckets. Most years fit into the more of the same bucket. A forecast is of little value except to assure the executive that doing the same as last year will work. That’s why businesses invest so little in forecasting. It usually has little value. The second bucket contains those odd years when things are different: as in 2020 and 2021. Those are when a good forecast pays off. Sadly those years are hard to forecast in timing and depth of the change. We are reminded that an in-depth study of such possibilities may not improve the forecast. But it will markedly improve a business’ response.

In the early 2000s, I studied pandemics and entered 2020 with a pretty good understanding of what might happen medically. I was not prepared for the unprecedentedly dramatic government response. Who could conceive of Manhattan shutting down? However, my study of cycles allowed me to predict with some accuracy the behavior of the economy once the restrictions were lifted. I predicted a capacity crisis in March of 2020 when the shutdowns were just starting. As usual, I missed a lot, including the level of stimulus from a government rushing to create distance from its earlier economically disastrous policies. As a result, I underestimated the record level of the capacity crisis, even as I correctly predicted the robust additions of capacity that Federal statistics tell us is occurring. Such is the nature of operating in this second, uncertain bucket of forecasts.

Keep in mind that odd years have a market power far greater than the more numerous normal years. Hence this deep dive into the phenomenon of inflation, a factor likely to strongly influence your results for 2022 and 2023. If the modern money theorists are right and inflation falls back to normal, just file this report in your worst-case file. If the current trends continue, pull it out for several reads and search the business press for more commentary aimed at those uncomfortable, hard-to-forecast years.

REFERENCES

1 Keynes believed that sometimes demand became inappropriately weak and needed stimulus

2 Austrian economists believe in free market economics and conservative money supply management, usually tied to a gold standard. They are called ‘Austrian’ because their beliefs were first laid out in writings by several generations of economists from Austria, particularly those of Ludwig van Mises. I am an Austrian economist.