Of Value Chains and Inflation
What do central banks have to do with value chains? Traditionally, not much. I think that’s one reason for the resurgence of inflation in many countries during the COVID-19 pandemic. There had been little study of the connection between global value chains and monetary policy, so when disruptions in international trade flows began driving up prices in 2021, central bankers were uncertain about what to do. While politicians are playing a typical blame game—in the United States, Republicans have pinned the inflation surge on the Biden Administration’s spending, while Democrats point to the massive increases in shipping costs and import prices—something of a consensus seems to be emerging among economists that the responsibility for the unusually high inflation rates from 2021 through 2023 lies with central banks.
The question of how central banks should respond to value-chain disruptions has become the subject of serious study. One paper published earlier this year finds central banks’ interest-rate increases more effective in taming inflation and less damaging to economic growth in the midst of supply-chain disruptions than under more normal conditions. A different analysis, updated in November 2024, agrees that strained supply chains strengthen the effectiveness of monetary policy in controlling inflation. An International Monetary Fund study of 29 African countries argues that while central banks can’t keep supply-chain disruptions from driving up prices of traded goods, they can limit the impact on non-tradable products by raising interest rates quickly. An interesting paper based on European data finds that the greater a country’s role in international value chains, the more quickly the central bank needs to tighten monetary policy in the event value chains become unsettled.
The implication of this research seems to be that the Federal Reserve and other central banks should not sit on the sidelines if value-chain disruptions start driving up inflation. During the pandemic, they should have begun hiking interest rates sooner than they did. At the end of 2020, the members of the Fed’s Open Market Committee, which sets interest rate policy, projected that consumer prices would rise only 1.7% in 2021, so they took no action when value-chain tangles drove up their favored inflation gauge, the personal consumption expenditures price index. That’s why U.S. consumer prices soared, rising about 8% between January 2021 and the Fed’s approval of a very tentative interest-rate increase in March 2022. The bottom line seems to be that there’s nothing about global value chains that makes it intrinsically harder for central banks to control inflation.
Tags: inflation, value chains
This is a very interesting piece, and I’m surprised there isn’t more research on the topic. Surely there must be a more evident link between supply chains and central bank interest rates? I would imagine most actors in the value chains have lines of credit, that would inevitably be impacted by tighter monetary policy. Central banks essentially have one tool, which is to decide how expensive money is. I suppose this then becomes a chicken and egg situation, which makes my above question hard to answer. In the case of Covid, I assume the global response was such a shock to the value chains that the offer/demand ratio shifted quickly, causing prices to rise.
One obvious link between supply chains and central bank interest rates is the cost of holding inventories. In the United States, the nominal value of inventories rose by about 30 percent over two years starting in the early months of the pandemic, a time when interest rates and therefore the cost of holding inventories was unusually low. Inventory building, of course, contributed to the spike in ocean shipping costs that some now blame for pushing up the inflation rate.