Supply and Labor Problems: Easing or Persisting?
Supply chain and labor market problems have amplified and extended elevated inflation pressures. What has been happening and how will this impact the inflation outlook around the world?
Bottom line: Some of the pent-up demand and supply chain problems are easing, which will help the inflation trajectory into 2023, ironically to some extent as that rise in prices suppresses real income and consumption which, in turn, inhibits pricing power. However, inflation is also being impacted by structural forces (labor market, the energy crisis and deglobalization), creating the risk that inflation will not come down smoothly everywhere or across the board. Even so, further monetary policy tightening is only going to accentuate economic slowdown/recession risks. This will likely cause demand-induced disinflation, which, though not dealing directly with supply-side problems, will help to calm core and headline outcomes into 2023. The risk/worry is that while demand may help ease price pressures in the short to medium term, more persistent supply chain and labor problems may impair the supply side of economies on a more prolonged basis, thereby embedding more structural inflation pressures.
Figure 1: NY Fed Global Supply Chain Pressure Index
Source: NY Fed
Some Easing of Supply Concerns
The COVID pandemic and Ukraine war have caused persistent supply chain and labor market problems, but how are these changing during 2022? A range of data points to an easing of pressures, but others are less clear. Additionally, the picture is complicated by a slowdown in global growth in 2022, which is causing demand-side disinflationary pressures.
One measure for an overall sense is the NY Fed global supply chain pressure index (Figure 1), which is showing some signs of less intense pressures. The index uses PMI sub-components (delivery time, backlogs and purchased stocks) alongside freight industry measures across major economies. A number of reasons exist for this easing in pressures, in the shape of the shift to endemic COVID policies in most countries ex China and a lessening of pent-up demand after the initial reopening post-COVID.
In the U.S., goods consumption to total consumption has peaked (Figure 2), as U.S. consumers have switched to consumer services and additionally slowed overall consumption (as seen in the recent real PCE consumption numbers). This has not fully fed through into CPI and PCE inflation due to lags, but we see this occurring over the next six months.
Figure 2: U.S. Goods Consumption to Total Consumption (%)
Source: Datastream, Continuum Economics
The supply chain problems of 2021 were acute in the auto sector, but latest U.S. data suggests that these problems are easing (Figure 3). The large German auto industry is still facing problems, although some of these pre-date the pandemic. The decline in semiconductor prices in 2022 is also in sharp contrast to the surge in prices in 2021.
Figure 3: U.S./Germany Motor Vehicle Production
Source: Datastream, Continuum Economics
It is not just the auto industry that is seeing reduced supply pressures. Figure 4 shows that excess German orders vs. production has peaked and is now easing, which should bring relief to German PPI ex energy and then into CPI inflation. Meanwhile, global transport costs are easing, as forward buying on logistic fears is less intense and also as inventory/sales ratios are better balanced (Figure 5).
Figure 4: German Orders minus Production and PPI ex Energy (%)
Source: Datastream
Figure 5: Container Freight Rates (USD)
Source: FBX
On a wider perspective, two of the inflation forces (post COVID pent-up demand and supply chain problems) appear to be easing, which not only means less monthly inflation for some components but in some cases could also mean a partial reversal of previous price increases. However, the COVID pandemic and Ukraine war are causing three structural hangovers in the shape of labor market problems, an energy crisis and deglobalization.
Labor Market Problems and Deglobalization Persist
The labor market recovery from the 2020 pandemic shutdowns has been strong to the point that vacancy rates have surged beyond recent historical experience (Figure 6). More workers deciding to retire, extend education or shift to a different work/life balance are some of the reasons cited by statistical agencies for this trend. However, a contrast exists across countries due to different labor market conditions. Figure 7 shows that the U.S. participation rate has failed to recover, whereas in the EZ (Figure 8) a surge in under-25s in the labor force has helped to trigger a healthier labor supply response. This is also the main reason why EZ wage inflation is more controlled than U.S. wage inflation and why we continue to look for only gradual ECB normalization (here) in contrast to the Fed. Japan also sees little sign of excess wage inflation, though the UK suffers from similar issues to the U.S., amplified by Brexit curtailing EU labor supply movements into the UK.
Figure 6: U.S. and EZ Job Vacancy Rates (%)
Source: Datastream
Figure 7: U.S. Participation Rate (%)
Source: Datastream, Continuum Economics
Figure 8: EZ Workforce (millions)
Source: Eurostat, Continuum Economics
In the EM world, labor market conditions are also different from the U.S. (Figure 9), with labor market slack in Brazil, South Africa and to a degree also in India and China — though data is not high-frequency, anecdotal reports support this idea. Labor market tightening is more localized, we feel, and is reflected in our inflation forecasts across the countries that we cover (see June Outlook). Even in the U.S., we now see signs that wage inflation pressures are peaking (here), due to a slowing economy, some discouraged workers returning to the workforce, and 2022 wage increases not being impacted as much by reopening pressures as 2021.
Figure 9: BICS Unemployment Rate (%)
Source: Datastream, Continuum Economics
Even so, some industries will still be affected by labor mismatch problems for years to come. Tourism and related industries are now seen to be less desirable by employees given the 2020-21 turbulence, which has prompted labor hiring problems and caused capacity issues. Flights have been canceled (Figure 10) and in the U.S. led to airfares being structurally higher than the past decade (Figure 11).
Figure 10: 2022 Flights Canceled as Percentage of Total Flights (%)
Source: OAG
Figure 11: U.S. Airline Fares — CPI category (1982-84 = 100)
Source: BLS
The second major issue is the global energy crisis. Before the Ukraine war, we had argued that the overreliance on gas for electricity generation against a backdrop of surging EM electricity demand risked a prolonged energy crisis. This has been amplified by the Ukraine war and EU coal and seaborne oil sanctions. Russian oil (Figure 12) can be redirected to other countries, but this will take into 2023 due to existing contracts and legal concerns. Demand concerns in the past six weeks have depressed crude oil prices, but this is exaggerated by hedge fund long liquidation. A tight oil supply and inventory situation will likely mean that oil prices recover into year-end, as the EU bans kick in and on winter precautionary demand. Into 2023 this oil supply situation can push WTI to $110 by end-2023.
Figure 12: Global and Former Soviet Union Oil Production (mlns B/D)
Source: U.S. EIA
European gas prices are exceptional relative to the oil price trajectory (Figure 13). European use of gas to heat residential property alongside electricity production leaves Europe more exposed than the U.S. to gas prices. The dependency on erratic Russia imports vs. U.S. self-sufficiency means that EZ gas prices have surged dramatically and are causing a major shock to EZ households and industry, in contrast to U.S. gas prices that have surged less. In the worst case, this could mean a major German recession (here). The situation is unlikely to be resolved quickly, as a comprehensive peace deal on Ukraine to normalize energy imports is unlikely in the coming years and Russia is weaponizing its energy resources. Instead, continued war in Ukraine or a frozen conflict will leave Europe trying to move away from Russian energy. Russia will intermittently try to disrupt gas imports into Europe to try to cause a split between Europe and the U.S. on Ukraine. The nature of gas infrastructure means that it will take years for Europe to build sufficient LNG import facilities and implement demand suppression measures to move away completely from Russian gas — Figure 14 shows the IEA projections of the maximum that is feasible over 12 months.
In the baseline view, this does not mean that EZ gas prices are substantively higher in 12 months, but it does argue against a major decline — a complete stop of Russia gas would cause a super spike in gas prices and rationing. For Europe, this is more of a problem than the U.S., as falling gas prices would quickly help to get inflation back to target.
Figure 13: Gas and Oil Prices (Jan. 2, 2019 = 100)
Source: Bloomberg
Figure 14: Slow Move Away From Russian Gas (BCM)
Source: IEA
The final structural issue is deglobalization. The COVID crisis prompted a refocus from just-in-time global supply chains toward greater resilience involving some near- or onshoring of part of the supply chains and also some industries reshoring. The Ukraine/Russia war is causing companies also to consider whether supply chains should involve countries that could face sanctions and whether to move production chains to friendly countries. Russia's direct role in global manufacturing supply chains is low, but China remains central to global production. In reality, China's ambitions toward Taiwan in the next five years are unlikely to involve invasion, which would cause Russia-style sanctions and disrupt global supply chains. However, the U.S./China strategic competition (and resulting trade tariffs) shows no signs of easing and will likely intensify in the coming years, with the GOP likely to win the House of Representatives in November and Donald Trump seen most likely to win the 2024 presidential election. Though China's wages have increased substantively since joining the WTO in 2004, pressure to reshore or use friendly countries still means that cost of goods production will likely be higher than the hyper competitive 2000-2019 era.
Overall, the energy crisis suggests that high prices will not reverse quickly, while deglobalization will mean more elevated global goods inflation than the golden era before 2020. However, tight labor markets are localized rather than a global phenomenon, which suggests that wage inflation is not guaranteed on a second-round basis. Additionally, slowing global demand will also likely mean some disinflationary pressures alongside the effects of fiscal and monetary policy normalization. All of this thinking is embedded in our 2023 CPI inflation forecasts and policy rate forecasts (Figure 15), which involve a switch to easing cycles in the U.S., Brazil and Mexico. The one caveat is that the greatest uncertainty surrounds the U.S., where the tight labor market conditions could cause PCE inflation to be more persistent and cause the Fed to move to truly restrictive policies (here).
Figure 15: Continuum Economics 2023 CPI Inflation and end-2023 Policy Rate Forecasts
Source: Continuum Economics