All You Need to Know About Inflation: The Reality of Supply Chain Shortages and Money Supply

Editor's note: markets, and the factors that affect them, are shifting all the time. Though much has changed since this article was published, the information here remains timely and relevant to current trends at the close of 2021. As we discussed in our November Thirdlies, inflation remains a major contributor to our financial hurricane-warning forecast. The following is a primer on this hot topic, as well as a look at supply chain woes and lags in production output. For specific questions on how inflation may impact you, and how to prepare for potential market volatility, please don't hesitate to contact us at our contact page or by calling (425) 778-6160.

For many of us, the “new normal” of staying at home has provided an opportunity to jumpstart home projects. A few weeks ago, I made one of my regular trips to Home Depot to pick up a sheet of oriented strand board (more commonly known as OSB, a cost-effective alternative to plywood) for a project. My jaw dropped when I saw the price tag —the cost was nearly four times as much as I paid a year ago! A jump in price shouldn’t have been that much of a surprise, considering we’ve been in the throes of a global supply-disrupting pandemic, but I still found this price hike rather incredible and a sign of emerging inflationary trends.

The threat of inflation is again making headlines, adding yet another dose of uncertainty to an already dramatically uncertain time. Although this can feel turbulent, the CWM team continues to keep our eyes on historic and current indicators to paint a more contextual picture.

Inflation is a natural part of an economic system and one that has been artificially suppressed over the last decade, initially in response to the Great Recession and most recently, in response to COVID-19 and global economic shutdown.

While inflation is the decline of purchasing power, to better understand our current economic situation, it’s helpful to think of inflation as the eventual outcome of prices responding to a rise in money supply, which has increased significantly from all of the government’s stimulus and the Federal Reserve (Fed)’s quantitative easing during the pandemic. In short, there was a lot of money added to the system in the last year, which could lead to high inflation. The question is whether this is going to be wholesale inflation, or if it’s simply short-term as a result of supply chain disruption and a temporary increase in demand (i.e., demand outpacing supply).

Some of the key factors that contribute to trends in inflation include:

• Money supply: How much money do consumers and businesses have to spend on goods and services? More money to spend generally correlates with higher demand, and higher demand encourages businesses to increase their prices. Interestingly, one of the current trends countering inflation is consumers’ increased savings rate, which is keeping some money out of circulation. With this trend, though, comes the risk that the additional funds in savings could flood the economy at a later point, contributing to inflation.

• Supply of goods: Are there enough goods available to meet the demand of consumers and businesses? One component that helps determine availability is the movement of those goods in the supply chain. Consumers and businesses can’t access the supply of goods when there are supply chain disruptions – the halt in traffic in the Suez Canal being a recent high-profile example – or labor shortages across the U.S. that slow the production and delivery of goods.

• Federal debt levels: When federal debt levels are low, borrowing costs typically remain low as well. When the government takes on substantial additional debt (for example, by issuing stimulus packages during a crisis), it’s more likely that interest rates will rise when the government continues to borrow at a high and rising volume. For example, on September 30, 2008 (the government’s fiscal year-end during the Great Recession), the federal government's national debt was a little over $10 trillion. As of April 19, 2021, it is a little over $28 trillion – almost three times as much just 12+years later! Let’s take a deeper look into how these factors come together, and what it means for us in the near term.

Supply Chain Constraints and Production Output

Due to government shutdowns of the major economies worldwide in response to COVID-19, economic and labor output is lower than it once was, so the supply of goods available is lower than current demand – contributing to inflation. Two key issues are disruptions and bottlenecks in our global supply chain. For example, manufacturers can’t produce and ship completed products if they don’t have all the parts (or the people) to produce them. Computer chip shortages have caused a slow-down in the production of cars and throughout the past year, millions of components sat idly on cargo ships waiting to unload at ports around the world – even before the historic backup in the Suez Canal.

Source: Briggs, Joseph and Walker, Ronnie. (March 16, 2020) The Inflation Boost from Supply Chain Disruptions: Here Today, Gone in 2022. Goldman Sachs Economics Research

The good news here is that we think this is short-lived. Our opinion is that the inflation we are seeing right now is due to demand exceeding supply— the result of massive supply chain disruption. We expect that as the global economy continues to reopen and supply chains return to their pre-COVID form with companies running their factories at full capacity, we should see supply catch up to demand while prices decrease.

The human component of the supply chain is labor. Many families with children or adult dependents have not had access to in-person school or care during the pandemic and have had to leave the workforce as a result. An estimated 1.08 million people left their jobs in August and September 2020 alone, with women leaving at a rate four times higher than that of men¹ and “studies estimate that employment for women may not recover to pre-pandemic levels until 2024”². Add to this the expanded federal unemployment benefit of $300 per week in addition to any existing state unemployment benefits, and some employers believe workers have more of an incentive to stay home. These expanded unemployment benefits end on September 6, 2021, and schools are working to reopen (at least partially), and we hope that by year-end we should see more workers off the sidelines, helping to resolve supply chain and manufacturing disruptions.

Another way we can visualize these concepts is by looking at economic output pre- COVID-19 and comparing the data with our present situation. Not too long ago, we were benefiting from the lowest unemployment rate in over 50 years while the heavy trucking industry, an economic indicator we like to use, was at full capacity, signifying healthy levels of business and consumer spending. When COVID-19 emerged, the economy was shut down and the Fed lowered short-term rates to zero, resulting in the K-shaped recovery in which we find ourselves now.

Source: Parker, C. (September 25, 2020). World Vs Virus podcast: An economist explains what COVID-19 has done to the global economy. World Economic Forum

The Correlation Between Interest Rates and Inflation

For a close-to-home example of how interest rates affect prices, and as we’ve seen throughout 2020 when we outlined home refinancing options, lower interest rates have stimulated interest in purchasing homes, dramatically increasing demand and playing a role in the booming housing market. With so many consumers looking to purchase homes, builders have needed to increase the supply available to prospective buyers. However, supply chain issues combined with higher demand for materials and other factors have led to a limited supply of construction components, further squeezing the already tight housing market. As a result, home prices have skyrocketed. This same price effect can be seen in other areas of our economy as well, such as manufacturing.

Just as limited supply affects inflation, all-time low-interest rates (and subsequent inflation risk) also correspond with high federal debt levels. Due largely to the pandemic, the U.S. recently experienced the largest year‐over‐year increase in federal debt on record, and the highest debt‐to‐GDP ratio since World War II. Eventually, higher levels of debt issuance will start to run into resistance from investors unwilling to make purchases at such low-interest levels, or even to sell their current bonds, which will put upward pressures on interest rates. This will be especially true if the Fed lessens some of its economic support efforts or short-term inflation rises sharply. Higher interest rates are inherently deflationary.

A year ago, we saw the inverse effect happening which laid the groundwork for where we are now when everyone was selling stocks and fleeing to the safety of bonds. During this time, increased demand pushed U.S. Treasury bond prices through the roof while driving interest rates down, contributing to the housing boom.

To conclude our example, low-interest rates combined with higher demand created a favorable seller’s market that continues to contribute to the steep rise (i.e., inflation) in home prices we’re seeing today. 

The Key to Inflation Recovery: Stuck in the Supply Chain

What’s interesting is that we currently have pockets of inflation in specific areas of the economy, but overall inflation for the everyday consumer is not that high; as shown in the chart below, we have more forces pushing prices lower as opposed to higher. Technology is a perfect example of an area in which we’re actually seeing deflation.

Our COVID-19- stricken economy and historically high levels of government debt are currently keeping inflation low. On the other end, inflation is higher in certain pockets of our economy (like manufacturing), most notably as a result of widespread supply chain constraints.

Source: Authers, J. (January 13, 2021). A Dead Soviet Economist Has Bad News for Stocks. Bloomberg.

Key Takeaway

As we are not seeing high wholesale inflation, the CWM team believes strongly that the inflation we’re facing will be a relatively short-term trend resulting from supply and labor disruptions spurred by the pandemic. We believe that eventually, supply will catch up with demand as businesses return to operating at full capacity and employees get back to work. Some amount of uncertainty will remain as vaccine rollout continues across the country and scientists continue to monitor the risk of emerging COVID-19 variants. Even with that uncertainty, CWM clients can rest assured that our team will continue to keep our eye on the markets, rooting ourselves always in the wisdom of focusing on what we can control, rather than on what we cannot.

Throughout the government shutdowns in response to COVID-19, your CWM team has been here to help navigate the various financial curveballs and help guide informed decisions. If you are interested in speaking with a CWM advisor about current market conditions or other planning-related topics, please call us at (425) 778-6160 or fill out a contact form here and one of our team members will reach out to assist you.

Additional Sources

¹ Connley, C. (October 2, 2020). 865,000 women dropped out of the labor force in September 2020 (cnbc.com). CNBC make it.

² Ryssdal, K. Palacio, D. and Corban, A. (March 18, 2021). The pandemic has been especially damaging to working moms - Marketplace. Marketplace.