How Broken Supply Chains Affect Inflation

This 8-minute podcast was released Jan. 12, 2022, as a part of the Timely Topics podcast series.

Ana Maria Santacreu, senior economist at the St. Louis Fed

“Over the past few decades, production has become more global … and as a result, the production process today is more fragmented and is more complex than what it was several decades ago,” says Ana Maria Santacreu, senior economist at the Federal Reserve Bank of St. Louis. Santacreu talks with Shera Dalin, media relations coordinator at the St. Louis Fed, about her research on supply chains.

Transcript

Shera Dalin: Welcome to the St. Louis Fed's Timely Topics podcast series. I'm Shera Dalin, your host for this episode, and today I'm speaking with Ana Maria Santacreu, senior economist with the Federal Reserve Bank of St. Louis. Thanks for joining me today, Ana Maria.

Ana Maria Santacreu: Thanks for having me.

Dalin: So glad you could be here. So, Ana Maria, since the COVID-19 pandemic began, you've been analyzing how the supply chain or, as the industry refers to it, the global value chain has been affected. As most people are aware, goods have been stuck in ports and can't get to retailers and customers. So, first, give us a little history. How have global value chains changed over the last few decades?

Santacreu: So, over the past few decades, production has become more global. What this means is that, instead of taking place in one single location, the production of a final good or an intermediate input involves many countries over several stages of production. And this sequence of stages in the production of a good or a service that involves many countries is what forms our global value chain. In the last few decades, global value chains have become more important. So, products that were labeled as "Made in China" or "Made in the U,S." before, now should be labeled as "Made in the world," and as a result, the production process today is more fragmented and is more complex than what it was several decades ago. And this has had its benefits. So, for example, a firm does not need to produce everything in house, and, instead, it can source its intermediate inputs from countries that are better at doing them, either because they are more efficient or because they have lower cost of production or simply because they have the raw materials that are needed at that particular stage. But, this complex structure of production is also risky, and one of the main risks that has been the center of our current debate on supply chain disruptions is that the firms that are participating in these value chains are exposed not only to domestic shocks, but also to shocks that are hitting their foreign suppliers.

Dalin: So, what happened to global value chains during the COVID-19 pandemic?

Santacreu: So, the current pandemic has exposed several of these risks. During the first month of the pandemic, the world experienced shortages of personal protective equipment, like masks or gloves or respirators, that were critical to combat COVID, and only a few countries were producing these goods, where the rest of the world was relying on imports. And the global nature of the pandemic and the fact that it was difficult to scale up production quickly led to supply shortages and price increases around the world. Second, there were global lockdowns implemented by several governments to contain the spread of the virus, and that disrupted the supply of several sectors of the economy. So, what we observed was that countries that had more severe lockdowns or countries that source their imports from other countries that were experiencing strict lockdowns also experienced more supply chain disruptions. And more recently, there has been a crisis in the shipping sector. There's been delivery delays, shortages of workers for unloading containers from ships in the main ports or more recently a shortage of drivers of trucks. And all that has led to bottlenecks. And on top of that, there has been a surge in the demand for certain sectors of the economy, like computers, automobiles, electric cars, that have created a mismatch between demand and supply, and all that has led to inflation.

Dalin: What recommendations do you have for alleviating the problems with global value chains?

Santacreu: So, this is a very important question. So, let me answer it with two more questions. So, the first one is how can firms increase their resilience of their global value chains? And here, several academics and policymakers have emphasized the importance of diversifying global value chains across many suppliers instead of just depending on a few countries to supply their imports. And in this way, firms and businesses can minimize their exposure to shocks that are affecting one single producer or one single country. Now, the downside of diversifying global value chains is that it's difficult to do that in the short run. And the main reason is that there are large, fixed costs that are involved in setting up contracts between the different suppliers and reversing these fixed investments may be very costly and may create more challenges to a fast structuring of global value chains. So, we may want to think of this diversification as a medium-term or a long-term solution.

Now, another area of discussion at the firm level relates to what is the ultimate level of inventory that a firm should have to avoid supply chain disruptions. Right now, inventories are very low because production has been organized around just in time production, and this has been efficient in the past, but it's also subject to shocks, like what we saw with personal protective equipment or what we saw with semiconductors. So, there, the demand for these products increased, but production could not adjust quickly and that drove inventories to almost zero. Now, because supply could not keep up with demand, the inflation went up. So, firms may have to start internalizing some of the risks that create these disruptions. Some of these shocks that they have been experiencing presently may have been perceived as threat events in the past, but they seem to be coming more frequent and I'm not just talking about pandemics. I'm also referring to geopolitical risks, natural disasters, protectionist measures, and again, all these are medium-term or long-term solutions.

So, now, the second question is whether there's any role for the government to minimize supply chain disruptions, and here, we could think of a combination of industrial and trade policies. So, first, governments need to be able to identify what critical sectors in an economy are more vulnerable to supply chain disruptions. And once they have done that, the government could create national stockpiles in those sectors so that they are hedged from future shocks. And this, again, is a challenging task because, unfortunately, there's not enough real-time data that governments can use to identify where the main sources of vulnerability are. Trade policy could also be used to alleviate the problem. For instance, international trade agreements among main allies can be used to diversify production of different goods across those countries with a commitment that, if a crisis hits one of the allies, the rest have the capacity installed to help out. The problem here is how enforceable these agreements are when there are global shocks affecting all the countries simultaneously, as we experienced with the personal protective equipment shortages during in the pandemic. Then, all the countries are going to need these goods and are not going to want to help out on this dimension.

So, here, there are more open questions than answers, but clearly, governments, businesses, and international organizations need to work together to find solutions for the medium or for the long term that can protect firms that rely on foreign suppliers from shocks that are hitting those suppliers.

Dalin: Well, thank you for sharing your insights and your analysis with us, Ana Maria, and we look forward to learning more about your upcoming research.

For more from our Timely Topics podcasts and to see more of Ana Maria's research, visit the St. Louis Fed's website at stlouisfed.org. You can also stream and subscribe to all of our podcasts on Apple Podcasts, Spotify, or your favorite podcast app.