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Capital Comments: Supply Chain Pressure is Easing, and so is Inflation

Inflation is falling, and we’re not in recession. How can that be?

The 12-month inflation rate began to rise in early 2021 and peaked at 8.9 percent in June 2022. Since then it’s fallen to 3.3 percent. Not so low as we (or the Federal Reserve) would like, but definite progress. 

That’s what the Federal Reserve’s policymakers had in mind when they began to raise the federal funds interest rate in March 2022. That interest rate was near zero; now it’s 5.3 percent. Other interest rates have followed. The average rate on a 30-year mortgage is up from 4.2 percent in March 2022 to 7 percent now. 

Higher interest rates are supposed to slow the economy. Fewer homes are built. Fewer construction workers are hired. Workers cut back on their spending, which reduces sales for businesses. Businesses buy less equipment, both because it’s expensive to borrow and because consumers don’t want to buy the added goods that the equipment will produce. Sales decrease, unemployment rises, and recession threatens. Declining sales mean businesses can’t raise prices so much, so inflation decreases.

That hasn’t happened. The economy has slowed, some. Home construction and sales are down. Business equipment purchases are growing more slowly. Job openings have fallen from 12 million to 9.6 million. But the number of unemployed people has not increased, remaining just under 6 million. The unemployment rate remains in the mid-3 percent range. After a year and a half of interest rate increases, we are most definitely not in recession.

The Federal Reserve fights inflation on the “demand-side” of the economy. Make borrowing more expensive, cut consumer and business spending, reduce the demand for goods and services, cause inflation to fall. Output and employment growth slows or turns downward.

Inflation is falling but output and employment continue to grow. That’s what happens when the “supply-side” of the economy is improving.

The pandemic wreaked havoc with the world’s supply chains. There were shortages of construction materials. Computer chips could not be had. Oil prices spiked. Transportation costs increased. Labor became scarce as older employees retired. Prices went up because of higher production costs and the scarcity of goods.

Researchers at the New York Federal Reserve Bank wanted a way to keep track of supply troubles, so early last year they released the Global Supply Chain Pressure Index. You can find it on their website, at Click on “Economic Research.” The index combines measures of ocean shipping costs, air freight costs, and surveys of business managers on delivery times and backlogs. Many of these measures are published by private companies for a fee, so are unavailable to most of us. The New York Fed publishes the index monthly, but also calculated figures all the way back to 1997, so we can get a sense of what’s normal and what is extraordinary over 26 years. 

Normal supply conditions are measured at zero on the index. Negative numbers mean less supply pressure – lower transportation costs, fewer shortages and delays. Positive numbers mean more supply pressure. The index averaged near zero in 2019. It rose to 3.1 in April 2020, dropped for a while, then spiked to a 26-year high of 4.3 in December 2021. That’s when inflation was rising, just before the Fed began raising interest rates.

Then the index began to fall, fast, dropping past zero in February this year, to -0.9 in July. That’s a drop of more than 5 points, by far the biggest reduction since 1997. Supply pressures have eased in the last year-and-a-half.

Ocean shipping costs must have fallen, air freight rates must have dropped, and delivery backlogs must have cleared up. The costs of doing business have stopped rising so fast. There is less need to pass higher costs to consumers in higher prices, and in some industries, competition may force price reductions. 

Inflation is falling, and we’re not in recession. How can that be? Because inflation isn’t falling solely due to restricted demand. It’s also falling because of more abundant supply. The lingering effects of the pandemic on supply conditions have faded. 

That’s a reason why, just possibly, we may get inflation back down to where we want it, without need of a recession.

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